CORNELL UNIVERSITY LIBRARY ( DATE DUE 1 SEMrtl "0^ 1 .."^'' j ( t 1 i \ CAVLORD PHINTEDINU S A Cornell University Library HB171.5 .J66 olin 3 1924 032 609 095 Cornell University Library The original of tliis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924032609095 INTRODUCTION TO ECONOMICS BY ALVIN S. JOHNSON, Ph.D. PROFESSOR OF ECONOMICS IN THE UNIVERSITY OF TEXAS . V (r BOSTON, U.S.A. D. C. HEATH & CO., PUBLISHERS 1909 A.a5C\ a small number of establishments control the greater part of the output. A movement that is even more striking than the concentration of industry is the formation of combina- tions among the enterprisers controlling an industry. This movement is, in part, a direct result of concentration. When the number of producers becomes small, it is rela- tively a simple matter to unite them for a common purpose. The tendency toward combination is, however, not a neces- sary result of concentration ; we may therefore best treat the two movements separately. Combinations are most frequent in the fields of trans- portation and manufacture. Most of the railways of the country are combined in a few great systems ; most of the manufacture of steel is controlled by half a dozen great combinations, and the same thing is true of illuminating oil, tin plate, sugar, and a great variety of other industries. The production of copper and the smelting of silver and gold-bearing ores is largely controlled by combinations. A combination of great capitalists controls the mining of anthracite coal ; in some parts of the country the mining of bituminous coal has fallen under the domination of com- binations. Indeed, we may say that the tendency toward 137 138 INTRODUCTION TO ECONOMICS combination manifests itself in practically every branch of economic life. 2. Combination may take the form of a union of pro- ducers that, as independent units, would be in active competi- tion with one another. The combinations that first attracted serious attention in the United States were organized in the field of railway transportation. Two roads, uniting the same terminals, in- stead of competing recklessly for business, often formed agreements dividing the traffic on what appeared to them an equitable basis. In most of the early industrial combi- nations, the members forming the union were engaged in the same stage of the process of production, and hence were active competitors until the combination was formed. Such were the steel rail, the tin plate, and the wire nail combinations in the iron and steel industries. Similar com- binations have existed among the paper manufacturers, the smelters of the more valuable metals, the distillers, and the binding twine manufacturers. It is associations of this kind that are commonly designated by the term combination. 3. Combination may assume the fonn of a union betiueen establishm.ents engaged in different stages in the process of producing and m.arketing a commodity. One of the earlier phases in economic development was the distribution of the various stages in the production of a commodity among a number of industries or sub-indus- tries. The manufacture of woolen cloth represented sev- eral independent industries : washing and sorting wool, carding and spinning, weaving, fulling, dyeing. The dis- tribution of the product to the various consuming centers gave rise to another independent line of business, the wholesale trade. The work of placing the finished product in the hands of the consumer was taken over by another business, the retail trade. In recent years an opposing tendency has made its BUSINESS COMBINATIONS 139 appearance. The entire work of preparing and distribu- ting a commodity is, in many cases, undertaken in a com- bination of establishments representing a single enterprise. One company mines coal and iron ore, transports these materials in its own ships and over its own railways, trans- forms the materials into pig iron for use in its own steel plant, and sells the finished product — rails, structural ma- terial, etc. — directly to the final purchaser. There are furniture makers that advertise the fact that every stage in the process of production, from the felling of the tree to delivery at the customer's door, is under their control. Shoe manufacturers own the tanneries that supply them with material, and chains of retail stores that place the product before the consumers. This uniting of all the stages in the process of production in one combined enter- prise is known as the integration of industry. Integration and combination in the restricted sense often go hand in hand. The United States Steel Corporation is a combina- tion of producers in the final stage in production, as well as a combination of producers in different stages of the process. 4. Some combinations are temporary in their nature. Even in an industry which is apparently so unfavorable to combination as agriculture, temporary combination is becoming fairly common. Farmers often combine for the purchase of machinery, seed, or other suppUes, or for the shipment of their products to distant markets. Similarly, petty retailers combine in the purchase of goods from the manufacturers, thereby gaining the benefits of purchasing in large quantities. A number of newspapers often unite in sending a correspondent to a war or other center of popular attention. Groups of financiers often form combi- nations, known as " syndicates," to subscribe a loan which would tax too seriously the resources of any one. Combi- nation of the nature here described is often termed business I40 INTRODUCTION TO ECONOMICS cooperation. It is to be carefully distinguished from labor cooperation, a system under which the laborers seek to rid themselves of the control of an employer. Another form of temporary combination has for its pur- pose common action in fixing prices. In the year 1908 there was a widespread combination among cotton pro- ducers with the object of holding their cotton for a fixed price. Competing railways frequently agree upon charges for a limited period of time. Groups of speculators often combine to force up the prices of commodities or securities over which they hold a temporary control. 5. Some combinations, though permanent in nature, in- clude in their scope only a small part of the activities of their several members. In many parts of the country the growers of fruit have formed associations for the purpose of controlling the marketing of products. In his business as a fruit grower, each member of the combination is entirely independent ; each member endeavors to excel his fellows in quantity and quality of output. Long experience of the exactions of the transportation companies and the commission mer- chants has led to united action in the marketing of products. Some of the larger associations have agents who visit all the important consuming centers and make the most favor- able terms with the merchants who deal with the consumer. They also have agents whose duty it is to watch over the movement of cars bearing the products of the association, and to take note of the condition of the products at the time of delivery. In some countries dairymen and poultry producers have organized similar associations. Most of the newspapers of the country are combined for the purpose of gathering news. This work has become so complex that a paper which cannot avail itself of the Associated Press dispatches has little chance of survival. In every large city the banks maintain a clearing house, BUSINESS COMBINATIONS 141 where the claims of the various banks upon one another are settled. So important is this function of settlement that a bank which is excluded from the clearing house is seriously handicapped in its business. In some German industries the several establishments, while acting independ- ently in the domestic market, maintain common agencies to handle the export trade. In many cases in American industrial history attempts have been made to control by combination the aggregate output of an industry, and so to fix prices. The several enterprises were left free to pursue their own policies in matters of production ; in matters pertaining to the mar- keting of products they were subject to the control of the combination. This form we shall consider further in a later section. 6. A combination may merge the several establishments into a single enterprise. This form of combination is known as a consolidation. In the great industrial enterprises of to-day, such as the United States Steel Corporation, the Standard Oil Company, and the American Sugar Refining Company, the separate establishments have completely surrendered their independence of action. Each establishment has its own officers, but these are chosen by the combination, or "parent" corporation, which thus determines their policy in every important respect. Several hundred combina- tions of this nature have been organized in the last ten years. So important are these combinations that many persons believe that the days of individual enterprise in the field of industry are numbered. 7. The earliest effective form of permanent combination for purposes of price control was the "pool" an agreement distributing the amount of business to be done, or the receipts from the business, among the several enterprises. In the period following the Civil War competition be- 142 INTRODUCTION TO ECONOMICS came so keen in many lines of business as to force prices to the cost level, or even lower. This was especially the case in railway transportation. At first an attempt was made to maintain rates through formal agreements; but each railway, in its zeal for increased business, was strongly impelled to cut rates in spite of its agreement to maintain them. Various devices were employed to restrain this tendency toward cutting rates. The most successful of these were the " pools." A number of railways, com- peting for traffic between two centers, would agree upon a division of the traffic ("traffic pools") or upon a division of the receipts from the traffic ("money pools"). Thus in 1870 the three railways connecting Chicago and Omaha made an agreement by the terms of which each road was to accept whatever through business was offered, at a rate set by mutual agreement. Each road was to retain for itself 45 per cent of the earnings of the through passenger business and 50 per cent of the earnings of the through freight business. The remainder of the earnings was to be placed in a fund to be shared equally by the three companies. This arrangement remained in force for prac- tically fourteen years ; it was finally destroyed by hostile legislation. A similar plan was adopted by the Bessemer Steel Pool in 1896. Each mill was assigned a certain percentage of the total amount of steel that was to be produced by the association. If any mill exceeded its allotment, it was re- quired to pay $2 a ton on the excess to the treasury of the association, and an equal sum was paid to those members of the association who fell short of their allotted output. In this way a restraint was placed upon the more active producers, and prices were maintained at a decidedly profitable level. This pool, like the great majority that have been formed, was short-lived. Some of the more powerful members became dissatisfied with the percentage BUSINESS COMBINATIONS 143 of output allotted to them and withdrew, leaving the pool too weak to maintain prices. 8. A stronger form of combination was created by placing a majority of the shares of stock in each constituent company permanently in the hands of trustees. This form of com- bination is known as the trust. In 1882 the stockholders of the leading petroleum reiin- ing corporations, which had for many years operated in har- mony under informal agreements, placed a majority of their stocks in the hands of nine trustees. For the stock surrendered to the trustees, the owners received certificates entitling them to a share in the profits of the combination. The power to vote the stock was transferred irrevocably to the trustees, who were thus in a position to determine the policy of each company. This form of organization was adopted by several other powerful combinations. By a federal law of 1890, known generally as the Sherman Anti-Trust Law, the trust was made illegal, so far as it affected interstate commerce, and most of the states have passed laws prohibiting trusts. This form of combination, therefore, has been destroyed. 9. A permanent combination may be established through the formation of a corporation for the purpose of securing control of a majority of the stock in each of the companies which it is sought to combine. Such a corporation is prop- erly termed a holding company ; in popular speech it is called a "trust." When the trust form of organization became outlawed, men who sought to attain the same end hit upon the de- vice of organizing a corporation with power to purchase and hold the stocks of other companies. The laws of several states, especially those of New Jersey, are very favorable to this form of organization. Accordingly, when a group of powerful producers desire to form a permanent combination, they secure a charter, wfe will say from the 144 INTRODUCTION TO ECONOMICS state of New Jersey, authorizing the formation of a cor- poration with extensive powers, including the essential one of holding stocks in other companies. They then ex- change their shares in the business corporations which they control for shares in the new company, and endeavor to induce other persons interested in the same industry to do likewise. Or the new corporation may place its shares on the market, and use the proceeds in the purchase of shares of producing companies. In this way it is possible to bring a large part of an industry under a single control. The process of thus merging a number of enterprises into one is known as " consolidation." The so-called trusts of to-day are organized in the way described above. In some cases the holding company, in- stead of buying shares in a producing company, buys its plant outright. In many cases it fails to secure a majority of the stock in such a company, but secures a sufficiently large minority of stock to make its influence decidedly felt. 10. Consolidation increases the productive efficiency of the several establishments. Where a number of establishments are competing, it is to the interest of each to retain exclusive possession of such improvements in methods as it may succeed in mak- ing. If an improvement consists in a mechanical inven- tion that can be patented, the establishment which secures it is protected in its monopoly by the law. It is conceiv- able that each one of a score of competing companies may thus retain exclusive possession of a device that the others could use to advantage. Consolidation permits each com- pany to make use of all the patented devices originating in the establishments of the other companies. The United States Steel Corporation is at present erect- ing, at Gary, Indiana, a steel-making plant which is to em- body every idea that has proved profitable in any of the plants of the company. It is anticipated that steel will BUSINESS COMBINATIONS 145 be manufactured more cheaply at the Gary plant than is possible in any existing steel works. No company not having the combined experience of the Steel Corporation could hope to establish a plant of equal efficiency. The manager of one out of a number of competing establishments knows only in a general way what success his rivals are enjoying. One establishment may produce steel at slightly less cost than another, without attracting special attention. When one plant in a great combination shows a lower cost per unit of output than do the others, the fact is at once known to the officers of the combina- tion, who naturally seek to learn the causes of this supe- rior efficiency, in order to introduce improvements in the establishments of less efficiency. Thus in a consolidated enterprise there is a resistless tendency to force every establishment to keep pace with the one which displays the greatest efficiency. 11. Consolidation encourages a higher degree of speciali- zation in production than does the system of competitive enterprise. An independent establishment, in order to retain its customers, is often compelled to cover a comparatively wide range of production. This involves keeping on hand a large amount of machinery which can be used only for a small part of the time. It also involves, in many cases, the production of goods for which the supplies of mate- rial upon which it relies are not especially well adapted. A consolidated corporation can send orders received to those plants which are in the best position to execute them promptly and efficiently. 12. Consolidation makes possible the supplying of each customer from the plant nearest to him, and thus reduces cost of shipment. Where an industry is competitively organized, there is a tendency for each producer to invade the territory nat- 146 INTRODUCTION TO ECONOMICS urally belonging to his competitors. Castings for use in Alabama should naturally be made in Alabama ; castings for use in the Pittsburg district should naturally be made there. But if there is competition between makers of castings in the two centers, some of the products of Pitts- burg will be sent to Alabama, and vice versa. This is sheer waste, and consolidation puts a stop to it, to the advantage of the producer and of society as well. It is true that under the competitive r^givie informal agreements among producers to respect one another's ter- ritory kept this form of waste within bounds. But there was always disputed territory, in which freights were use- lessly carried back and forth. Consolidation has elimi- nated cross freights, except in cases where real differences in quality make supplying from a distant mill necessary, or where the nearest mill is temporarily overwhelmed with orders. 13. Consolidation reduces the chances of loss from over- supply or undersupply of the market. When an industry is carried on by a large number of competing employers, each one is in greater or less un- certainty as to whether he can market his products at remunerative prices. The causes for uncertainty are first, possible changes in the demand, over which the industry has no control, and second, changes in the combined out- put of the competing establishments. When a consolida- tion is formed, the second of these causes is eliminated. The producer knows exactly how great a volume will be placed upon the market. There is consequently less chance that great stocks will accumulate at a time when the demand is slack. When the volume of orders in- creases, the full extent of 'the increase is readily calcu- lated, and preparations may be made for a cqrrespondingly greater output, if an industry is consolidated. If an indus- try is not consolidated, each producer, although receiving BUSINESS COMBINATIONS 147 an increased volume of orders, is uncertain whether the expansion of the business is general or not, and so delays preparations for increase of output, with the result that at the height of business expansion he must turn away orders at profitable prices. Herein lies one of the chief advantages of the form of consolidation which we have described as industrial inte- gration. When the steel industry was competitively organ- ized, there was at one time overproduction of ore, at another time overproduction of pig iron, at still another time over- production of steel billets, even when there was no over- production in the final stages of the industry. Under present circumstances all stages in the industry keep pace with one another. If the demand for finished products appears to be on the increase, a symmetrical increase is ordered in the production of ore, pig iron, crude steel, and finished products. 14. Consolidation reduces the expenses incidental to the marketing of products. The marketing of products is, in many lines of industry, a very complicated process, requiring great expense for advertising and for the services of trained salesmen. A manufacturer must often make special concessions in prices or in conditions of payment in order to introduce his goods ; under competition he is always in danger of losing custom because of the efforts of his rivals to introduce their goods. Some efforts are of course necessary under the most favorable conditions to attract the attention of purchasers. But it is manifestly a more difficult problem to attract the attention of purchasers away from a rival's wares than to attract their attention to the general class of goods.. Con- solidation results in important economies in this respect. The Distilling Company of America is said to have saved ^1,000,000 a year through reduction in the number of trav- eling salesmen, made possible by combination. In many 148 INTRODUCTION TO ECONOMICS cases consolidated companies have been able to dispense with the traveling salesman, since purchasers, having no choice, are compelled to resor't directly to the producer. One of the more important sources of loss to the com- petitive producer was the failure of purchasers to pay for goods secured on credit. The producer could not refuse credit, since by doing so he was likely to lose customers. The consoHdated company can safely insist upon cash pay- ment, since it has few competitors to take its customers away from it. 15. The consolidation can usually borrow money on more favorable terms than any one of a number of competing producers. As a result of the manifold advantages of the consoli- dated company, the chances of its failure are reduced to a minimum. If it is conservatively managed, loans made to it possess a high degree of security, and consequently bear a low rate of interest. Moreover, the mere fact that the consolidation represents a vast aggregate of capital places it in an extremely favorable position in the loan market. Every one has heard of the Standard Oil Com- pany, the United States Steel Corporation, the Harvester Trust, the great packing companies. Every one has formed an estimate of the financial standing of these com- panies. Consequently the man who has loaned capital to one of these companies can easily sell his claim upon it whenever he desires to regain possession of his funds. A small refinery or slaughtering establishment may hold a position that is financially as sound as that of one of the great companies mentioned. But this fact is not generally known, and those who loan money to the lesser companies find far greater difficulty in disposing of their claims when they desire to do so. For this reason they demand a higher rate of interest than they would be willing to accept from the great consolidation. BUSINESS COMBINATIONS 149 16. The most important advantage arising from consoli- dation is the control over prices that it makes possible. All the advantages that have been enumerated would probably have been insufficient to cause an extensive movement in the direction of consolidation. Most of them could have been secured through a form of combination that would leave the independence of the individual estab- lishment practically unimpaired. Combinations of inde- pendent establishments for purposes of price control are, under the American system, opposed to the spirit of the law, and for this reason could not be satisfactorily main- tained. In Germany, where such combinations are recog- nized by law, there has been no tendency toward complete consolidation such as we have in America. It is still a disputed question whether consolidation has resulted generally in a material advance in prices. There are a number of cases in which it can readily be shown that these vast combinations have taken advantage of their monopolistic position to maintain prices at a level considerably above the competitive level. In other cases, consolidation appears rather to steady prices, preventing very low and very high prices, than to raise the average level. In any case, the rise in prices due to consolidations has been far less than a consideration of the monopoly position of these aggregations of capital would lead one to expect. The checks upon monopoly power, described in Chapter IV, appear therefore to be very effective. 17. Szimmary. There is at present a tendency toward the formation of combinations of business establishments. The term com- bination is properly applied to unions between establish- ments in the same stage in the production of a commodity or service ; it is, however, also applied to unions of estab- lishments in successive stages in the production of a com- modity. The latter form of combination is also termed 150 INTRODUCTION TO ECONOMICS industrial integration. Combinations may be temporary or permanent, partial or complete. The permanent and com- plete combination is known as a consolidation. The chief forms of combination have been the pool, the trust and the holding company. The pool and the trust have been outlawed ; existing combinations, commonly called "trusts," are of the holding company type. The holding company is a corporation which holds the stock of companies that are consolidated, and so controls their policy. The advantages of consolidation are (i) the increased ' technical efficiency of each establishment, through appli- cation of methods developed in other establishments; (2) greater opportunity for the specialization of each estab- lishment to particular grades of the commodity produced ; (3) reduction in transportation charges ; (4) avoidance of oversupply and undersupply; (s) reduction in cost of marketing; (6) reduction in interest charges; (7) control of prices. CHAPTER X COMPETITIVE WAGES 1. Labor is the application of human faculties to the pro- duction of wealth. We have found frequent occasion in earlier chapters to touch upon wages and interest. Wages and interest are parts of the cost of production of commodities, as we saw in Chapter V, and as such have an important part to play in determining values. In the present and the following chapters we shall endeavor to ascertain the laws deter- mining the rates of wages, interest, and whatever other forms of social income may remain after the shares of the laborer and of the capitalist are paid. In other words, we are entering upon a study of the distribution of wealth, or, more properly, of the distribution of the social income. Every expenditure of human energy having for its chief purpose the production or the preservation of economic goods, or the increase in the valuable qualities of existing goods, is labor, in the economic sense of the term. Labor includes not only the exertions of the manual workers, by whom actual changes in material commodities are wrought, but also the exertions of. the foremen, superintendents, managers, under whose direction the manual tasks are performed. It includes the activities of police, of judge, and of legislature, upon whose efficient performance rest the possibility of continued production in most of the exist- ing branches of industry. Labor does not include, how- ever, efforts undertaken for their own sake, without regard to economic result. The amateur football team spends an immense amount of energy, and gets its reward in the . 152 INTRODUCTION TO ECONOMICS spending. The amateur hunter often cares little or noth- ing for the birds he brings down ; his reward is the gratifi- cation of the prehistoric thirst for blood. The professional football player and the professional hunter, on the other hand, are laborers. If any one thinks that this is a dis- tinction without a difference, let him ask the football amateur what claim to superiority he enjoys over the "professional"; let him ask the sportsman wherein the latter differs from the pot-hunter. 2. Wages are the income received on account of labor per- formed. As the term " wages" is generally used, it signifies the money or other things of value paid by an employer to those who serve him in capacities of inferior dignity ; employees of higher rank receive "salaries." Political economy does not recognize any such distinction as this, based as it is upon the pretended social status of the recipient, rather than upon a difference of economic function. The ten cents a day paid to a child slave and the ^100,000 a year paid to the presi- dent of an insurance company are alike wages in the blunt speech of the economist. Moreover, in economic language, the term " wages " extends to part of the income of a workman who is his own employer. One peanut vender may be working for a push-cart enterpriser, receiving a dollar a day for his efforts. This sum, all will agree, is nothing but wages. At the opposite corner of the square you may find another peanut vender, who is his own em- ployer. The latter may gain, over and above the cost of raw nuts, gasolene, push-cart hire, etc., just a dollar a day. The two men then receive equal rewards for identical services. Possibly the second vender calls his income " profits." Political economy cannot afford to use two different terms to designate essentially the same thing, especially when one of the terms, " profits," has a very definite meaning of its own. Whatever a man receives COMPETITIVE WAGES 153 simply as a reward for his exertions, whether directly or through the intermediation of an employer, is wages. 3. Contract wages involve more important economic prob- lems than does the wage income of the independent work- man. While we cannot properly exclude from the term wages so much of the income of an independent workman as arises from his personal exertion, we are nevertheless justified in devoting our attention almost exclusively to wages as determined by contract between employer and employee. An increasing proportion of the world's work is being done under this system, and most of the impor- tant economic problems of the day are concerned with it. Who ever heard of a "labor problem" in an agricultural community where every farmer relies exclusively on his own two hands ? In such a community, what importance attaches to the general movement of wages, whether up- ward or downward 1 Indeed, who can determine, in such a society, how much of the total income of each farmer is wages, how much interest on capital invested in the farm } Wages have existed ever since our first ancestors were condemned to eat their bread in the sweat of their brows ; but it is only under modern conditions, where one man pays another to work for him, that it comes to be of great importance to ascertain what laws govern the rate of wages. We shall therefore confine our study to that part of the economic field in which differentiation between employer and employee has taken place — where the "wage system" exists — and shall endeavor to ascertain the laws operative therein. These laws, indeed, exert an influence in the rest of the economic field as well, and are in turn influenced by forces lying outside of the field in which the wage system prevails. What a man could get as his own employer helps to determine how much he must have as a mere wage-earner ; what he could get as a 154 INTRODUCTION TO ECONOMICS mere wage-earner helps to determine what he must gain as an independent workman. 4. The returns resulting from the employment of a given amount of labor vary according to the conditions under which labor is etnployed. Let us set before ourselves, in imagination, an agricul- tural community in which all the land is owned by a small class of men who do not themselves engage in tillage, but hire the landless population to work upon their fields. And let us further assume that this population is unable or un- willing to migrate to other communities in search of em- ployment. Whether there are many workmen or few, they must all seek employment upon the land, or starve. Some of the land in the community is fertile, some of it barren. Some of it requires a large expenditure of labor for every bushel of wheat or potatoes produced ; some of it yields rich crops with little labor. Every good field yields a moderate crop with a small expenditure of labor; if a larger crop is sought, it must be at the expense of a disproportionately large application of labor, as we saw in the chapter on Diminishing Returns. Accordingly, we may safely lay down the proposition that the results arising from the application of labor to dif- ferent fields, and in different methods of cultivation, will be unequal. Good land, in extensive cultivation, may yield three bushels of wheat per day's labor expended, while poorer land yields, perhaps, two bushels, and yet poorer land one bushel. Adding one day's labor to the amount previously spent on a piece of the best land may add only two bushels to the product, and adding still another day's labor may add only one bushel. 5. Equal wages for equal tasks is the rule of competitive industry. However unequal the results of labor on different fields and under different methods of cultivation, the reward of COMPETITIVE WAGES 155 labor — wages — will tend to be uniform, allowance made, of course, for differences in the physical efficiency of dif- ferent laborers. Suppose that a farmer has ten fields, of different degrees of fertility, and employs one man to cul- tivate each, the work on the different fields being uni- formly arduous. He would be a very unusual employer if he should propose to pay the men different rates of wages, according to the fertility of the field upon which each is employed. The probable result of such a plan would be that competition would arise among the men to win the employer's favor, each one desiring to be employed on the best field ; and in the end we should probably find that the better fields would be apportioned to the men who would agree to perform for the employer various miscel- laneous services which would, generally speaking, be equal in value to the advantages they enjoyed in the way of higher remuneration. How this would work out we might consider at greater length if we did not know by experi- ence that even the most liberal employer is averse to grad- ing the wages of his men, not on a basis of their skill and faithfulness, but on a basis of the facilities for work which the employer himself furnishes. Cases of unequal rewards for the performance of equal' tasks are of course to be found ; but for these cases the explanation, as we shall see later, is of a wholly different nature. Just as uniform wages will be paid for like tasks by any one employer, so uniform wages will be paid by all the em- ployers in the community. No employer can keep in busi- ness unless he pays as good wages as any other. If any one raises wages slightly, he will attract to himself an in- creasing number of workmen, and he will soon get all he cares to have. In an earlier chapter we saw that there cannot be different prices for the same commodity in the same market. This law holds good for labor as for any- thing else one buys or sells. IS6 INTRODUCTION TO ECONOMICS 6. The wages of any one of a number of laborers of equal efficiency will not exceed the addition to product made by the laborer whose services are least important to the employer. Of ten fields, the best one, when cultivated by one work- man, may yield a product worth $500 ; the worst one may yield only $ 1 50. What will be the maximum wage that the employer will pay ? Not more than ^150. For he will not pay any workman more than the entire product created by the aid of that workman, and he will not, of his own volition, pay one workman more than another. Nor can any work- man compel the employer to pay him more than the one on the worst field receives. Suppose that the one employed on the best field insisted on a wage of ;^200. The employer would dismiss him, and place on that field the laborer formerly employed on the worst field. And so with any one of the ten laborers. What the employer would lose, if any one of them should "strike," would be simply the product of the worst field — $1 50, according to our premises. If we assume that the ten fields are owned by different men, we arrive at an identical result. The employer who owns the poorest field cannot possibly pay more than ^150 to the workman who tills it. If a workman on a better field demands more, his employer will dismiss him, and put in his place the workman formerly employed on the poorest field, whom he can easily induce to change employers by offering him a trifle more than the owner of the poorest field is able to pay. The dismissed workman must live ; probably he will have to seek employment on the abandoned field, and content himself with the wages that the owner of that field can pay. If we assume, instead of ten fields of varying fertility, one large, fertile field, giving employment to ten men, we see exactly the same principle at work. One of the men, cultivating the land extensively, may produce t^co; a second may add to this product $450 ; a tenth may add to COMPETITIVE WAGES 157 the total product of the nine previously employed only ;?I50. The employer will not pay the first ^500, the sec- ond $450, and so on down to ^150. He will pay each one not more than ^150. If any one should demand more, he would be dismissed, and his functions performed equally well by the man who otherwise would have added only ^150. What the employer loses, when he loses any man of the ten, is the product created by the least important one of them all. 7. The wages of any one of a number of laborers of equal efficiency cannot, under competition, be permanently less than the marginal product of labor, or the addition to product made by the laborer whose services are of least im.portance to his employer. We have, then, an upper limit of wages above which an employer cannot be compelled to go : the addition to the total output created by the man who works at the greatest disadvantage. Is there, similarly, a lower limit.'' In the situation we have assumed — a number of competing em- ployers, each able to increase his employment of men through breaking up new, though less fertile, lands, or through more intensive tillage of lands already under cul- tivation — it is unlikely that any employer will make a large net return on the last man he employs. Let us assume that the uniform yearly rate of wages is ^120, while the product of the least important man varies from $\?.o on the least fertile farms to $175 on the most fertile ones. The man who has a fertile farm can increase his net income by offer- ing a little more than $\2<:> for an additional workman. Such a workman will not add ^175 to the total output — the law of diminishing returns forbids this — but he may add ^i 70. As the employer on the least fertile field secures a product of only $\'zo from his last man, he is compelled to let a man go. Perhaps the man who now becomes his least important hand is worth ;^I2S to him, and ^125 158 INTRODUCTION TO ECONOMICS may be what the man on the next better field is worth. It still pays the farmer with the best fields to seek additional hands. The wage he must now offer is more than ^125, — let us say, ^130. And the additional men will be worth less to him — perhaps ^165 each. Competition will still go on between the employers having the better fields and those having fields that are not so good, each rise in wages affecting, of course, the wages of all the workmen in the community. At last a point is reached where no employer can take a workman away from his competitor without offering a wage so high as to outweigh the advantages to be derived from an additional employee. Here, then, wages will tend to remain stationary. Each employer will be paying his least important man so much that any in- crease in wages would make that man an unprofitable member of his working force. No employer would care to take on an additional man at the existing rate of wages. This means that on every farm the least important work- man adds to the total product only enough to cover his wages. The addition to product made by the man working under the least favorable circumstances is, then, not only the maximum that the employer can be compelled to pay ; it is also the minimum which he cannot avoid paying. If we describe as the " product of labor," that amount of valuable product which is brought into being by the pres- ence of any particular laborer, we may say that, under com- petition, wages are determined by the product of the laborer working under the least advantageous circumstances (in this case, on the poorest land). This laborer is known in eco- nomics as the marginal laborer, as he is on the " margin " or fringe of employment, as it were — in a position where his continued employment is almost a matter of indifference to the employer, since his presence means neither profit nor loss. In the customary economic formula, wages, tin- der competitive conditions, are detertnined by the marginal COMPETITIVE WAGES 159 productivity of labor (i.e. the productivity of the marginal workman). ■8. An increase in the personal efficiency of labor tends to raise wages. Let us suppose that in the course of time the working force of our assumed community becomes more efficient, either through increased intelligence or through improve- ment in skill or in physical strength. This might well be the case if the community is a comparatively new one, with a population imperfectly adjusted to its environment. It would then be quite possible that the product of the men working under the least favorable conditions would in- crease, let us say, by ten per cent. Wages under competi- tion would also increase by ten per cent. Many causes besides changes in the personal efficiency of labor are operative in raising or lowering the level of wages. But it cannot be doubted that the extremely low wages paid in such countries as India are in large measure due to the low average efficiency of the laboring class. The high wages paid in America are in part accounted for by the fact that American conditions spur the work- man to an activity surpassing that of workmen in other countries. It has often been noted that immigrants from European countries work much harder than they did in their native lands. 9. An increase in the number of workers tends to reduce marginal productivity and wages. Now let us assume that the number of workmen in the community is increased by the immigration of equally ef- ficient workmen from another part of the country. The new men must have employment ; and there is of course plenty of work in the community for them to do — on one condition, however. They must accept employment on fields yet poorer than any now cultivated, or they must be added to the force at work upon the better land, occu- i6o INTRODUCTION TO ECONOMICS pying themselves with tasks that formerly were neglected. In either case they will add less to the product than was created by the marginal workman before the arrival of the new hands. They must accept a rate of pay lower than that which formerly prevailed, else no employer could afford to hire them. And as there will not be two rates of wages for equally efficient men, the general rate for all the workmen originally employed in the community must be reduced. If the immigration continues steadily, other things remaining the same, the marginal product of labor; and with it the rate of wages, must steadily sink. If, on the other hand, some of the original landless popu- lation should move away, some of the worst fields would be abandoned, and it would become impossible to cultivate the better fields as intensively as before. On each field the importance of the marginal man would increase. If any employer should persist in paying the old rate of wages, his competitors, by offering a little more, would entice his men away. The tendency for wages to rise, with decline in the laboring population, would be as irre- sistible as the tendency for wages to fall with an increase in population. 10. Improvements in methods of production tend, as a rule, to raise wages. Let us suppose that in this community are found exten- sive tracts of marshy land of practically no economic importance. A competent engineer enters the commu- nity, and at a comparatively low expense drains these lands and transforms them into the very best quality of tillable soil. The owners of the drained lands must have labor, and can bid a higher price than prevails generally. If the laboring population remains stationary, the effect of the new demand for labor is to withdraw men from the least favorable situations and place them upon the new land. On every farm the product of the marginal COMPETITIVE WAGES i6i workman is increased, and wages rise accordingly. If immigration of laborers is going on, the new demand for labor counteracts the effect upon wages of the new supply ; if emigration is taking place, the rise in wages that would otherwise occur is emphasized. A similar influence may be exerted by a general im- provement in agricultural practice. It is said that by the use of seed corn which has been grown in an isolated field from which all barren stalks have been removed before maturity, the average yield of corn may be increased from ten to thirty per cent. This increased yield is obtained without additional labor, excepting a small amount entailed by the care of the seed corn field. The use of such seed corn in the community we are studying would increase the product of every laborer, that of the marginal ones as well as that of the rest, and the competition of employers with one another would force them to raise wages in the meas- ure of the increased marginal productivity. The intro- duction of a new forage plant, like Kaffir corn or alfalfa, might have a similar effect in increasing the productivity of the marginal laborers. So also might the use of a new kind of fertilizer, or the invention of a new agricultural implement. Almost all agricultural improvements, in fact, are likely to have the effect of increasing the productivity of labor and the rate of wages. It is not in the least necessary that such improvements find general application. An improvement increasing the productivity of labor on one tenth of the farms will gener- ally lead to an increased demand for labor on those farms. The demand is met by the withdrawal of labor from the farms not affected by the improvement ; and this results in raising the productivity of the least favorably situated laborers on those farms, and so raises general wages. 11. A reduction in the rate of interest tends to raise wages. i62 INTRODUCTION TO ECONOMICS One other influence needs to be noted here ; namely, a fall in the rate of interest. There are few farms that could not be made to yield a much larger product, if abundance of auxiliary capital were to be had at a low rate of interest. If a farmer must pay ten per cent on borrowed capital, he cannot build a good barn or drain a marsh until he has accumulated a considerable amount of capital of his own. In the meantime opportunities for labor which would be thrown open if capital were to be had at five per ceht he untouched, and the existing labor supply is spread over barren fields, with consequent low productivity. Every reduction in the interest rate creates a new demand for labor, and withdraws part of the existing supply from the poorer fields, thus increasing marginal productivity and wages. 12. In a complex industrial society, laborers fall into many classes between which there is 710 direct competition. We may now sum up the results of our study of wages under the assumed conditions. Wages are determined by the marginal productivity of labor, but marginal produc- tivity itself is subject to many and varied influences, such as arise from increase or decrease in number of laborers ; increase or decrease in the amount of available land; the progress of improvements ; the fluctuations in the interest rate. Let us now see how far we can apply the same reasoning to the determination of wages under conditions nearer like those of modern industry, confining ourselves, however, to those parts of the industrial field in which competition exists among employers on the one hand and among workmen on the other. The first fact that we must take into consideration is that we cannot assume that in this wide field of industry every workman can enter into direct competition with every other workman, and thus bring about an immediate equalization of wages. The journeyman tailor cannot be COMPETITIVE WAGES 163 ^replaced by the excavator nor by the farm hand ; the cotton-mill operative cannot take the place of the iron and steel worker. At any given time, then, there may be many rates of wages, not one universal rate. As we enter upon a study of the forces which are responsible for the differences in wages in the various trades and occupations, we encounter a difficulty which has not hitherto arisen to vex us. How can we say what differences in general rates really exist .■' In all our dis- cussion up to this point, we have spoken of equal rewards for equal services. Of course if one bricklayer does twice as much work as another, he is Ukely to receive twice the • wages. But if a tailor receives twice the wages of a brick- layer, how can we say that it is because he does twice as much work? Clearly, it is not possible to reduce tailor's labor to terms of bricklayer's labor, so a^ to show whether one is rewarded more liberally than the other. 13. Through the apportionment of new additions to the working force, wages in different occupations requiring equal natural endowments tend tozvard an equality. Let us suppose that there are half a dozen occupations in a community, all of which require of beginners about the same degree of intelligence, dexterity, and strength, although they differ as widely in their nature as bricklayer's and tailor's labor, so that no direct comparison of wages is possible. Is there any reason why differences in wages per day should exist .■' At first, we should expect, the choice of occupations would be more or less a matter of chance. A boy would enter one of the trades because his father followed it; another, because his best friend in- tended to enter it, and so on. Once in the trade, a man would have to remain there, unless he wished once more to go through the tedious tasks of a beginner. The different trades would thus be walled off, as it were, one from the other. Mature reflec- 1 64 INTRODUCTION TO ECONOMICS tion might convince a man that he had made a mistake in choosing his trade ; but this would not mend matters. His earnings would be wholly subject to the laws of his trade. If many men happened to be in the trade, and the demand for their services were limited, some of them would have to be set at unimportant tasks, which could not be well re- munerated. And competition among the men would force wages down to the level of remuneration of these. If the trade were but scantily supplied with men, all might be employed at work that could pay a high reward, and so a high rate of wages would prevail. In each trade the rule that marginal productivity determines wages would apply ; but marginal productivity would be unequal, for men of equal native ability, in the different trades. In every trade, however, a constant supply of new re- cruits is necessary to keep its ranks full, and the pros- pective apprentice has at any rate some freedom of choice. In one trade, he finds men discontented and impoverished ; in another trade, he finds every appearance of prosperity- Unless he is very blind, he will choose a trade in which the latter condition prevails. So the tide of apprentices sets steadily away from the underpaid trades, and in the di- rection of the better paid ones. Failing numbers, in the former trades, raise the marginal productivity of labor; increasing numbers, in the more prosperous trades, re- duce wages there. Whether this process will continue until perfect equality of rewards is established for men of equal native ability in different trades, we cannot say. The equalization depends upon the good judgment of the prospective apprentices in their choice of trades; and these, like all men, are likely to err. But gross inequality, under the circumstances, could hardly long persist. 14. Permanent differences in competitive wages are caused by differences in the marginal productivity of labor, original- COMPETITIVE WAGES 165 ing in influences affecting the distribution of the supply of labor. Some of the differences in wages actually existing ap- pear to be fortuitous, as those assumed in the foregoing ex- ample. But many of these differences are clearly connected with the personal qualifications of the workman — his strength and skill, his intelligence and reUability. Others are connected with the different degrees of risk, agreeable- ness, and dignity of the employment itself. Still others de- pend upon trade union requirements, or legal restrictions. What we are concerned with here, however, is not to classify the causes of differences in the wages paid in different oc- cupations, but to see exactly how these causes operate. We know, for example, that a dangerous occupation is likely to carry with it a higher remuneration than a safe one ; that an occupation requiring a long apprenticeship is ordinarily better paid than one requiring practically no training. Why may we not' say, then, that a part of a man's reward is for labor, part of it for risk ? If a tedious apprenticeship is necessary, may we not say that part of the reward of the journeyman is a compensation for the time and trouble spent in learning the trade ? Such an explanation would be quite satisfactory if we actually found that, other things equal, wages were nicely graded according to risk, or to the length of the period of appren- ticeship — if, for example, we found that a workman in an occupation involving no appreciable risk received a wage represented by x, an equally efficient workman in an occupation involving a considerable risk received x-\-y, and a third workman, in an occupation twice as dangerous as the second, received ;r+ 2y, and so on. But we do not find in real life any such simple rule as this. Danger- ous occupations, we often find, are very ill paid in compari- son with occupations requiring no greater natural ability and entailing no risk worth speaking of. Almost the least 1 66 INTRODUCTION TO ECONOMICS remunerative occupation that an able-bodied citizen of the United States can engage in is that of soldier, and this in spite of the fact that the Federal government prides itself upon being a liberal employer. Certainly the risks of the occupation are considerable. A man who accepts employment as trainman on the American railways stands one chance out of one hundred and twenty of meeting a violent death within a year, and one chance out of nine of being injured. His average daily compensation will vary from ^2.09, if he is a fireman, to $4.25, if he is an engi- neer. In either case, he is a man of more than average physical strength and general intelligence. If he is an engineer, he is also a man who has at least as much train- ing as the average skilled laborer. What we really find is that in some cases no allowance appears to be made for risk ; in more cases some allowance is made for it, but there is no apparent tendency for this allowance to vary regularly with the degree of- risk. Similarly with dif- ferent degrees of skill. Ordinarily, the skilled laborer, who has undergone a long apprenticeship, receives a higher reward than the unskilled laborer of equal native intelli- gence. In some cases, however, this does not appear to hold true ; and it is idle to attempt to show that there is any ascertainable proportion between degrees of skill and dif- ferences of remuneration. So also with disagreeableness of work. Little, if any, allowance is ordinarily made for it in wages, although in some cases it seems to play a very im- portant part. Clearly, then, it is not enough to say that wages are affected byrisk, by skill required, by disagreeable- ness of occupation. We must know how these causes operate, and why they operate with such irregularity. Let us see if a concrete example will not make clear the relation risk actually bears to wages. Imagine that a gunpowder factory is erected at a distance of a few miles from a city of some size, and let us suppose that five COMPETITIVE WAGES 167 hundred workmen will be required, and that they will be of a grade of skill that would command an average of $2, a day in perfectly safe occupations. How much will it be necessary to add to this sum, to induce them to enter the powder works ? Now, the first question that is likely to arise is, How much danger is there that the works will blow up ? You do not know this, neither do I ; nor, we may venture to say, do the workmen whom it is sought to employ. Per- haps there is no danger at all in the present stage of the powder manufacture. Powder mills have often blown up, however, and most of us would prefer to stay out of them. In every community there are some men who do not seem to be in the least afraid of danger. They may know that destruction has befallen others, but, each argues, everybody can't be killed ; why should I be } Such men have supreme confidence in their luck. Danger, real or imputed, does not influence'^^heir conduct. Now, if there are a thousand men of this kind in the city, it will be quite possible to man the powder mill without offering any more of an advance in wages than would have to be offered by an enterpriser who proposed to establish a new shoe fac- tory or nail mill. The powder manufacturer, as any one else starting a new enterprise, will offer wages a little higher than those prevailing in the city — ten cents more per day, perhaps. Not every one will jump at the chance to improve his wages ; but the men who despise danger will one by one leave their former employments and enter the doors of the powder mill. Presently wages will be reduced to the general level. No man will for this reason leave the mill, nor need the enterpriser care if a few should do so, for there are still plenty of men in the city who are not disturbed by fear of accident. But suppose that instead of one thousand such men, there are only one hundred. The powder manufacturer 1 68 INTRODUCTION TO ECONOMICS will find that ten cents extra a day fails to bring the full complement of men. Perhaps he will offer twenty-five cents extra; and this may bring another hundred men, who fear for their lives, indeed, but desire the additional income extremely. An additional twenty-five cents may bring another hundred, more timid or less eager for high wages. At the rate of i^i a day above the prevailing rate, the enterpriser may be able fully to man his works. Now, we may ask ourselves, is this extra dollar a com- pensation for risk > Remember, there may be no real risk at all, and it may be that it is nothing but the name of powder that has kept the workmen back and forced up wages. And how is it that a powder manufacturer is able to pay men for risk, at their own estimate — very likely a mistaken one, too ? Well, the powder manufacturer is ex- periencing the ordinary incidents of his business. Every- where powder manufacturers have to contend with the same indisposition on the part of the ordinary workman to enter their mills. Everywhere the amount of available labor is limited, relatively to the demand for it. And so the productivity of a laborer, measured in value of powder produced, is high, and wages may be high accordingly. If, however, the number of men who do not mind the danger were sufficient fully to man all the powder works, more powder would be produced, its value would be less, and the productivity of labor, in value, would fall until it corresponded with that of labor in other occupations re- quiring equal skill. If the risks to life and Umb undergone by locomotive firemen and engineers were reduced by fifty per cent, through the introduction of better safety appliances, the improvement of track, etc., how much could wages be re- duced.' I have never heard of a railway president who proposed to spend the company's money in reducing the chances of accident with the expectation that part of the COMPETITIVE WAGES 169 cost might be met by a reduction in wages. Nor do we find that wages are particularly high in the sections of the country where transportation is conducted at the greatest cost in life and limb. Here, it appears, is a case in which a great industry is able to rely upon the existing supply of men who bear risks cheerfully, without any extra compen- sation. The marginal laborer, in transportation, is no more productive than the marginal laborer in general industry ; therefore he is no better paid. 15. The standards of living of the working class, through limiting the supply of labor, vmy affect marginal produc- tivity, and, therefore, may affect wages. Finally, we may consider the effect of the so-called " standard of living " upon productivity and wages. There are some who believe that wages are adjusted to the aver- age needs of the workman ; and if these needs increase, wages must rise. What a man feels that he must have, in the way of the material necessaries and comforts of exist- ence, is his standard of hving. This, according to certain optimistic social philosophers, he will get. Accordingly, if you are modest in your demands, you will receive a modest stipend ; if you are convinced that the world owes you not only a living, but a good living, the world will kindly accommodate itself to your view of the matter. Certainly, this theory is a far more agreeable one, and far easier to grasp, than the laborious one presented in this chapter. How much truth is there in it .■' If you are planning to become a physician, you are likely to seek the counsel of some who are now practicing the profession. You will probably receive some such advice as this : " Whatever you do, don't make a physician of yourself. A physician must dress well; he must live in a good house; he must keep a carriage; in short, he must Kve at great expense, and in the majority of cases, he will find great difficulty in obtaining an adequate lyo INTRODUCTION TO ECONOMICS income." Now, what this means is that physicians have a comparatively high standard of living, and that their aver- age incomes are scarcely sufficient to meet all the demands upon them. You may not be deterred by the doleful account of the physician's financial difficulties. But is it not probable that, in the length and breadth of the land, hosts of young men are in this way turned to other pro- fessions ? If, on the other hand, the majority of physicians were recommending their profession as one in which a good living is assured, is it not likely that many young men would be attracted to the profession ? In the former case the average income of the physician is likely to be increased by the growing scarcity of competent medical men ; in the latter case it is likely to be decreased by in- crease in numbers. If, then, the earnings in a profession or trade are not sufficient to command, on an average, the necessaries and comforts that are deemed essential to happiness, some in- fluence is exerted upon those entering the profession or trade. The standard of living thus exerts some slight influence, at least, upon wages. In the example just given, the effectiveness of the stand- ard of living in one profession depended upon the absence of a similar standard in other professions. Suppose that after getting the opinion of a physician as to the advisa- bility of entering his profession, you apply to a lawyer for his opinion on law as a profession. " Whatever you do, avoid the law," he will probably tell you. Next, you go to one who has chosen journalism. " I pity a young man who selects journalism as his profession," is probably what you hear. Then you go to a teacher. He shakes his head. " If I were a young man, I should choose some other pro- fession." Indeed, if you do not happen upon one of the few optimists who still survive, you are likely to conclude that you may as well choose the profession toward which COMPETITIVE WAGES 171 you were originally inclined, since all the professions seem to be inadequately paid. The fact is that most of us think that we need more than we get ; and the result is that no one profession is able to frighten aspiring youths into choosing some other line of activity. The standard of living of any profession, therefore, has little effect upon its average earnings. Suppose, however, that a whole nation, practically, is affected by this feeling of discrepancy between income and need. A considerable proportion of its young men will marry late or not at all, children will be few, and, if immigration is not active, the population will gradually decline. In every occupation, men will be withdrawn from the less important tasks ; the less fertile fields and the less productive mines will be abandoned. The marginal prod- uctivity of labor, and the average rate of wages, will in- crease. On the other hand, if a nation consists of people who will thankfully receive little if they cannot get much, who will forego one luxury or comfort after another rather than change their traditional mode of life, no check upon population will exist, until the bare necessaries of existence are insufficient for all. Here, as elsewhere, it is because the productivity of labor is low that wages will be low. Such people will obtain only a bare minimum of existence, because that is all the marginal laborer is worth, not be- cause that is all he needs. We may now sum up the principles which we have sought in the foregoing long array of apparently unrelated examples. The marginal productivity of labor is under competition the immediate determinant of wages. Risk or disagreeableness of labor, the skill required, the bar- riers to be surmounted, the standard of life, may all affect the rate of wages, but only in so far as they affect the marginal productivity of labor, through determining its supply. 172 INTRODUCTION TO ECONOMICS 16. Summary. In the widest use of the term, wages include any income originating in labor. In a narrower sense wages are the price paid by one person for another person's services. While the productivity of labor varies with the conditions under which labor is employed, wages for tasks of equal difHculty tend toward a uniform level. This level is deter- mined by the addition to product made by the laborers who might be most easily dispensed with, or the marginal laborers. Wages tend to rise or fall with increase or decrease in the personal efficiency of labor. An increase in the labor supply, other things equal, reduces wages. Improvements in production usually tend to raise wages, as does also reduction in interest rates. There is little direct competition between laborers in the several occupations; but the apportionment of the supplies of new labor tend to prevent any great inequality in the rewards of men of equal natural ability. Permanent differences in wages are the result of barriers preventing the free flow of labor from one field to another, such as a long period of apprenticeship, risk, trade union regulations. The standard of living can affect wages only through reducing the supply of labor. When the wages paid in a given industry are not high enough to meet the require- ments of the existing standard of living, young men may be discouraged from entering the industry, and hence wages will tend to rise. When general wages are inadequate, in view of the general standard of living, increase in popula- tion may be checked, and thus wages may be raised to a higher level. CHAPTER XI WAGES AS AFFECTED BY LABOR ORGANIZATION 1. Where laborers are not in a position to deal with their employers on substantially equal terms, actual wages may remain below the level fixed by marginal productivity. In the last chapter we saw that under full and free com- petition wages are fixed by the productivity of labor employed under the least favorable conditions. What laborers produce, in the least productive fields, mines, and factories that are actually under operation, sets the standard toward which the wages of all labor tend. In many cases, however, actual wages fall below this standard. The posi- tion of the laborer in bargaining with the employer is often very weak. The employer needs workmen just as the laborer needs employment; but the need of the laborer is usually far more pressing than that of the employer, since the former has no adequate reserve to draw upon for his living expenses, while the latter has such a reserve in his capital. Where industry is conducted on a large scale, the employer can without serious inconvenience dispense with the services of any one of his numerous employees. An employee, on the other hand, cannot abandon his position without running the risk of a long period of unemployment. Under the conditions, there is every reason why the labor contract should, in a majority ' of cases, be more favorable to the employer than to the employee. Average wages will be less than the average value of labor, measured by marginal productivity standards. 2. When the terms of employment are fixed, not by agree- ment between the employer and individtml workmeri, but by 173 174 INTRODUCTION TO ECONOMICS agreement between the employer and an organized body of workmen, wages conform more closely to productivity standards. The disadvantages under which the workmen suffer are in large measure removed by effective organization. The employer may be able to get on very well without the services of a particular employee ; but if all his employees quit his service at one time, he is likely to suffer severe losses. The employer may have customers whose needs must be supplied, if they are to be kept from opening business relations with his competitors. He may have notes falling due, which can be renewed only if his business gives evidence of prosperity. A prolonged stoppage of work may result in the employer's ruin; in any case, it is likely to inflict serious injury upon him. Rather than accept such an evil, he is disposed to make concessions to his employees, so long as their demands do not appear exorbitant. Indeed, there are cases in which the employer can be compelled to pay his men more than their labor is worth, according to the general standard that the industry can, in the long run, afford. But these cases are rare, and, in a general study of the effects of labor organization upon wages, may be ignored. 3. The typical form of labor organization is the trade union, an association of laborers employed in the same trade. In a trade which has become well established, a natural basis for organization is found in the mutual sympathy of those whose lives are passed under like conditions. One carpenter knows how to evaluate the problems of life and work of another carpenter. Even where there is no formal organization in a trade, we find a tendency among the mem- bers to work in harmony. They assist one another in finding work ; members of the trade who are prosperous contribute to the support of those members who fall ill or are otherwise overtaken by misfortune. Moreover, the WAGES AS AFFECTED BY LABOR ORGANIZATION 175 typical workman is reluctant to underbid a fellow-workman of the same trade in his dealings with an employer. Com- petition, then, is materially restricted even in trades with- out a formal organization. With the appearance of a class of large employers, the inchoate organization of labor developed into the formal organization which we call the trade union. In its simple form, the trade union is an association of all, or of a large proportion, of the men exercising a trade in a given locality. The association has regular meetings where the conditions of employment are discussed, and rules are adopted governing the conduct of members. Officers are elected for the purpose of systematizing the work of the association, and of enforcing its rules. It is rarely the case that all persons in the trade are members of the union. Some workmen are averse to the restrictions upon their personal liberty that unionism rep- resents ; some are unable or unwilling to assume the finan- cial responsibihties that membership entails. Where the strife between the workers and the employers is not intense, the relations between members of the union and non-mem- bers may be entirely amicable. The non-members work alongside the members, and demand and receive the same wages. Where the union laborers are engaged in a con- flict with their employers, they usually manifest hostility to the non-union men, since the latter may accept empldy- ment, to the great injury of the cause of the union, and in any event fail to carry their fair proportion of the burden of the struggle, though hoping to profit by it. 4. As a matter of practical policy, a strong trade union usually endeavors to induce all men exercising a trade to be- come members of the organization. Sometimes union men are forbidden to work for employers who employ non-union men. This is known as the " closed shop " policy. It is evident that the presence in an industry of a large 176 INTRODUCTION TO ECONOMICS number of men who take no part in the existing labor organization materially weakens the position of the organi- zation. The union, therefore, uses every means to per- suade all persons in the trade to become members of the organization. If any refuse, and the union possesses the necessary strength, it forces them to become members by harassing employers who admit the non-union men to their shops. This policy is often denounced by represent- atives of the employing class as an unwarranted interfer- ence in the rights of the non-union men. It is further denounced as an attempt to compel the employer to assist the union in controlling its membership, \yhether the closed shop policy is justifiable or not depends entirely upon the general policy of the union. If it admits to membership all men having the necessary qualifications for the work to be done, upon payment of reasonable membership fees, it is difficult to see how the men who are compelled to become members have any real grievance. So long as the demands of the union for higher wages or shorter hours are moderate, the impartial outsider cannot censure the organization for making its position as strong as possible. 5. The trade union, whenever possible, places limits upon the number of persons admitted to the trade. If the wages of skilled workmen in any trade rise much above the general level, there is likely to be an influx of laborers from other employments, whose presence in the trade has the effect of reducing wages. In some cases the free admission to a trade of all who desire to exercise it would reduce wages below the normal level. In the build- ing trades, for example, wages appear to be higher than they really are. The members of these trades receive high wages for the time they are employed, but employ- ment is very uncertain. In the greater part of the country, the winter represents a slack season in which WAGES AS AFFECTED BY LABOR ORGANIZATION 177 very few members of the building trades find steady employment. This irregularity of employment does not receive due consideration from young men who are about to choose a trade; hence unrestricted admission to the trade might easily depress annual earnings below the normal level. Restrictions upon entrance to a trade may take the form of apprenticeship regulations that are sufficiently onerous to reduce the number of beginners. Formerly, a seven-year apprenticeship was required in many trades. During the period of apprenticeship, the worker received no wages, and this in itself narrowly Umited the number of persons who could afford to enter a trade. In some trades, an apprenticeship of three or four years is still required. Another method of limiting the number of apprentices is to prescribe the proportion of apprentices to trained workmen that an employer may have in his shop. In the job printing offices of New York City, one apprentice is allowed to every office employing as many as eight men, and for every additional eight men an additional appren- tice is allowed ; but no office may employ more than seven apprentices. The work that apprentices are allowed to do is hedged about by restrictions that prevent the employer from gaining much profit from it. It is easy to see that through such restrictions upon ap- prenticeship an artificial scarcity of labor in any one trade may be created, and wages may be kept at an abnormally high level. Those who are prevented from exercising the trade are forced into occupations where such limitations upon the labor supply are impracticable, thus depressing wages in those occupations. Consumers of the products of industries in which labor holds a monopolistic position are forced to pay abnormally high prices. There are, however, very few trades strong enough to raise wages 1 78 INTRODUCTION TO ECONOMICS much above the level that the degree of skill necessary would, in the long run, command, even if admission to the trade were perfectly free. 6. The position of a trade union is greatly strengthened by the accumulation of funds for the relief of members in time of sickness or unemployment. The mere wage earner is at all times exposed to the danger of want as a consequence of accident, sickness, or prolonged unemployment. What he can save individually is seldom sufficient to carry him through a long period of time in which he earns nothing. The trade union, by col- lecting contributions from those members who are receiv- ing wages, and by distributing the money among those who are in need, greatly reduces the uncertainties of the laborer's lot. A plan of mutual insurance binds to the union many who would otherwise hold themselves aloof from it. Moreover, it keeps those who are out of work from offering their services to the employer at a reduced rate of pay, and thus prevents the demoralization of the labor market. But the most important object to be attained through the accumulation of funds is the strengthening of the union in a dispute with the employer. With a large fund, a union may be able to keep its members from accepting work through a period of several months — long enough to in- flict serious losses upon a recalcitrant employer. A union without funds may be easily starved into submission to the employer's conditions. 7. The position of a union is strengthened by an alliance with unions in related trades, or even in unrelated trades. Such trades as the carpenters, the masons, the plasterers, and other building trades, have much to gain through working in harmony. At one time the carpenters may have a strong organization, and the masons a weak one ; at another time the reverse may be true. On one job a WAGES AS AFFECTED BY LABOR ORGANIZATION 179 small number of masons may be needed, and a large num- ber of carpenters. In such cases, the union masons could perhaps be replaced by the non-union masons that are to be found in every city, while it would be more difficult to secure a sufficient number of non-union carpenters. The building contractor must have men of each trade, and if he engages in a dispute with the union whose position is weak, pressure can be brought upon him by the 'Union whose position is strong. A harmonious organization of allied trades can thus always place its strongest forces at the front. An advantage of a different nature arises from an alliance of unions in unrelated trades. The cigar makers' union can bring no direct pressure to bear upon the employers of garment workers ; but when the garment workers are thrown out of employment by a strike, the cigar makers can contribute to their support. At another time contribu- tions from the garment workers may assist the cigar makers in securing better terms from their employers. In the principal industrial centers of the United States, both kinds of alliances are found. All trades form a loose organization known as the Central Labor Union ; related trades, such as the building trades, form closer organiza- tions, known under various names in the different cities. 8. A trade union in one locality is strengthened by an alliance with unions in the same trade in other localities. In a period of such easy communication as the present, a purely local labor organization can accomplish little. In a dispute between the labor organization and an employer, the latter can quickly import laborers from other localities to replace his former employees. Apprenticeship regula- tions in one locality are enforced in vain, if in other locali- ties the labor market is overstocked through unrestricted apprenticeship. Even when no importation of labor takes place, the local union finds difficulty in raising wages or reducing working i8o INTRODUCTION TO ECONOMICS time. Such measures represent a cost to the employer, and if the product is one which must enter into competition with like products from other localities, the concessions that the employer can make to his employees are narrowly Umited. If the textile workers of Fall River demand higher wages, the employers may be unable to grant the demand without raising the price of cloth to such an extent as to encourage the competition of other textile manufactur- ing districts. The importance of a central organization appears nowhere more clearly than in the case of industries in which exten- sive consolidations have been formed. If the laborers in one steel plant demand higher wages, the plant can be closed down, and the orders executed in other works where there is no trouble with the laborers. The employer loses practically nothing, and the laborers are in the end com- pelled to return to work on such terms as the employer may dictate. In any event an organization covering a wide range of territory affords an excellent means of raising funds for local organizations in time of labor disputes. When the cigar makers of New York are on strike, the cigar makers in Philadelphia, Boston, Chicago, and other cities raise funds for their support. The foregoing considerations have led to the formation of national or international unions in almost every impor- tant trade. In government these organizations are some- times loose federations, sometimes strongly centralized bodies. In the centralized unions the local union is re- quired to obtain the consent of the national union before inaugurating a strike ; the national officers can call a strike in any locality, even if the members of the local organiza- tion are content with their condition. The essence of the power of the national union is its control over the funds that are accumulated for emergencies. A local union WAGES AS AFFECTED BY LABOR ORGANIZATION i8i which goes on strike without proper authorization forfeits its claim for strike benefits from the national organization ; a local union which refuses to strike when ordered to do so is suspended or expelled from the national union, and is subjected to more or less severe discipline before it is rein- stated in the organization. 9. National organizations have much to gain through a central organization covering the whole field of industry. In the United States most of the national unions are associated in a great central organization known as the American Federation of Labor. This organization fur- nishes a means by which the support of the entire trade- union world may be given to unions engaged in an extended contest with their employers. The American Federation pretends to no direct control over its constituent members, but unions about to engage in a labor dispute naturally consult with the officers of the Federation arid seek the cooperation of that body. The American Federation col- lects information relating to the entire field of labor and assists in organizing unions in new fields. When disputes arise between different labor organizations, the ' Ameri- can Federation officials act as arbitrators ; when factional strife causes the disruption of a union, the officers of the Federation are active in effecting a reorganization. With the lapse of time the American Federation will probably gain additional strength, and will demand a voice in all questions of general importance to the laboring class. 10. The principal weapon in the hands of organized labor is the strike. A strike is a concerted suspension of zvork for the pufpose of enforcing some demand upon the em- ployer. Sometimes the mere fact that demands are presented to the employer by an organization including his entire work- ing force leads to concessions that would never be made to isolated employees. In many cases, however, the em- 1 82 INTRODUCTION TO ECONOMICS ployer refuses to consider the demands of his employees, and a strike is called. It is possible that the employer would be unable to grant the demands even if he desired to do so. In perhaps a majority of instances the demands could be granted in part or wholly without serious loss to the employer. At all events the laborers beheve this, and in suspending work they feel that they are merely stopping operations long enough to reach a satisfactory adjustment of the matters in dispute. Sometimes the employer takes the same view of the matter and makes no attempt to replace his striking workmen. If the employer feels that the demands of the men are wholly unreasonable, he is likely to attempt to fill the places left vacant with laborers who are not controlled by the organization of the strikers. This the latter must pre- vent, if they are to have any chance of winning. If there is nowhere' to be found an adequate number of laborers willing to work as strike breakers, the strikers may be content to allow the employer to experiment with ineffi- cient men. If the efforts of the employer to secure laborers appear to be successful, the strikers endeavor to persuade the strike-breaking laborers to join in the sus- pension of work. " Pickets " are stationed at the en- trance to the works, to inform all men coming to their tasks that a strike is in progress. If the strike breakers do not yield to peaceable persuasion, the pickets often resort to intimidation. Where the contest becomes very bitter, the strikers sometimes employ violence to frighten the strike breakers from their work. The employment of violence is discountenanced by the leaders of the strike; nevertheless, a great strike has seldom been entirely free from instances of injury inflicted upon strike breakers. 11. A second weapon of organized labor is the boycott. A boycott is an association having for its purpose the destruc- tion of the business of an employer through pressure brought WAGES AS AFFECTED BY LABOR ORGANIZATION 183 to bear, directly or indirectly, upon those who have business relations with him. When men are on strike, they naturally refrain from purchasing the products of their former employer, and persuade their friends to follow the same course of action. This is a simple form of the boycott; it may be fairly effective when the product is destined for local consump- tion by the working class. An employing baker, for example, may be brought to terms in this way. Where the product is placed upon a general market the boycott takes a more complex form. The whole trade-union world may be warned not to buy the products of the offending employer. This may be done through the pub- lication in the trade journals of the name of the employer who is the subject of attack. For a long time an " unfair list," a list of the names of such employers, was published by the organ of the American Federation of Labor. This form of boycott has been held by the courts to be illegal, but it is practically impossible to do away with it. Sometimes the boycott takes a very roundabout course. A merchant is boycotted for handling the products of an "unfair" shop; laborers are boycotted for buying goods from such a merchant; men who employ these laborers are boycotted, and so on. These roundabout boycotts are not very frequent nor very important. They are of doubtful value to the laborers' cause, as they inflict more hardship upon innocent parties than upon the persons against whom they are ultimately directed. 12. Strikes and boycotts may be carried on by workmen who have no formal organization. We have spoken of strikes and boycotts as the weapons of organized labor. As a fact, however, a great many strikes take place in trades that are not organized in unions. For the purpose of carrying on a strike a tem- porary organization is effected which may be abandoned 1 84 INTRODUCTION TO ECONOMICS when the strike is won or lost. Boycotts, under one name or another, have often been employed by unorganized laborers. Even in an organized trade it often happens that the non-union men join the union men in striking. This was the case in the last strike of the Fall River textile workers and of the anthracite coal miners. In such cases the or- ganized laborers usually assume the leadership. It is not certain whether the formation of trade unions leads to an increase or to a reduction in the number of strikes. It is undoubtedly true that a permanent organ- ization results in a reduction in the number of strikes having no adequate cause. A trade union develops re- sponsible leaders who do everything in their power to prevent a strike when the chances of winning are small. 13. In many trades where powerful organizations have been established, the terms of employment are fixed, not by bargaining between the employer and the individual work- m.en, but by agreements between representatives of the laborers, on the one hand, and representatives of the employers, on the other. This plan q-"^ fixing the terms of employment is known as t^'^i'^e-bi ^^ki.^g ,^. In the bitufffeousV-i^'^^*^" rict of the North Central states representatives of the mmers and representatives of the mine operators meet annually to determine the rate of wages to be paid. In these meetings all the circum- stances of the industry are fully discussed, — the prices that the product is likely to command, the cost of placing it on the market, the cost of living of the workmen, the wages paid in other districts, etc. As a result of the dis- cussion each side gains a fairly clear understanding of the position of the other. It becomes impossible for the la- borers to insist upon terms that the employers cannot possibly grant, as not infrequently happens where no machinery for collective bargaining has been established. WAGES AS AFFECTED BY LABOR ORGANIZATION 185 Differences of opinion as to what constitutes a fair wage naturally arise ; but through full discussion and mutual concessions these differences are prevented from causing a rupture of negotiations. Since the adoption of the plan of joint conferences agreements have always been reached, and have in most cases been loyally observed by both em- ployers and employed. In a number of other American industries similar meth- ods of collective bargaining are employed, and in England, where trade unionism is more powerful than in any other country, all the great industries establish the conditions of employment by collective bargaining. It is clear that in a complex modern industry, only the more general conditions of employment can be fixed by such agreements. Minor disputes will constantly arise relating to the interpretation of the general agreement. Provision is usually made for the settlement of such dis- putes by a committee representing both the workmen and the employers. Where such a committee is unable to reach a decision, resort is had to the services of an impar- tial outsider who acts as arbitrator. In some industries there is a general understanding that if no agreement as to the renewal of the contract can be reached, the matters in dispute shall be settled by arbitra- tion. Such arbitration, however, is not always successful, since either the laborers or the employers may prefer to submit to a trial of strength rather than accept the onerous conditions of the arbitrators' award. 14. When a strike has been in progress for a long time, and both parties to the dispute are thoroughly wearied with it, though either is unwilling to surrender its claims, resort may be had to arbitration. In perhaps a majority of the important strikes of recent years each party to the controversy has taken a position which is not wholly defensible. The demands of the men 1 86 INTRODUCTION TO ECONOMICS are excessive, and the terms that the employer insists upon are unnecessarily onerous to the men. Negotiations are broken off and a strike follows, to the serious injury of both parties. As the burdens of the struggle grow heavier, each party sees that its original position was untenable, but shrinks from making concessions, fearing that to do so would be to confess itself worsted in the struggle. The only way in which the difficulty can be settled without loss of prestige to either party is through submission of the matters in dispute to arbitrators mutually agreed upon. Both parties bind themselves to accept the award of the arbitrators in good faith, and instances are rare in which this agreement is disregarded. The award of the arbitrators is seldom anything more than a balancing of concessions ; it usually satisfies neither party, but is ac- cepted as a lesser evil than a continuance of the struggle. 15. Arbitration may be forced upon the parties to an in- dustrial dispute by the pressure of public opinion. While the persons most seriously injured by the continu- ance of an industrial dispute are the laborers and employ- ers directly involved, no important strike can be conducted without injury to the public. Inthe Chicago teamsters' strike of 1905, while the losses to the strikers and the employers were estimated at about $3,000,000, the loss to the business men of the city was estimated at several times that amount. A strike of railway laborers almost inevitably injures inno- cent parties more than it injures the railway companies against which the strike is directed. The blocking of the street railway system of a great city through a strike in- flicts immeasurable injury upon the general public. The anthracite coal strike of 1902 occasioned great distress among the poorer classes of those parts of the country that are dependent upon anthracite coal for fuel ; the re- sulting high price of coal caused the closing down of many shops and factories with consequent losses in wages and WAGES AS AFFECTED BY LABOR ORGANIZATION 187 profits. In almost every great strike instances of violence are frequent, and the charges upon the public for maintain- ing the peace are greatly increased. Accordingly there are the best reasons why persons representing the interests of the public should undertake the task of bringing about a reconciliation between the employers and their striking employees. In some cases those who undertake this task limit themselves to inducing the disputants to meet in conference to discuss the matters at issue. This may of itself lead to a settlement of the dispute. Such intervention is known as conciliation. In other cases an attempt is made to force the disputants to submit to arbitration. Thus in the coal strike of 1902 Presi- dent Roosevelt induced the coal mine operators and the miners to submit the dispute to an arbitration commission appointed by himself. In a similar manner Governor Douglas, of Massachusetts, effected a settlement of the Fall River strike of 1904. 16. It would be a great gain to society if industrial dis- putes could be submitted to arbitration as soon as they arise, instead of toward the close of a long contest. No argument is necessary to show that a strike is a wasteful way of establishing the conditions of employment. Since a settlement is likely to be effected by arbitration, why is a long and expensive struggle necessary ? Why do not the disputants resort to arbitration at the outset .? In most cases an industrial dispute is based upon irrecon- cilable differences of opinion. The employer offers what he considers the fairest terms he can afford to give ; he believes that the laborers will be compelled to accept these terms in the end. The laborer demands what he regards as the lowest wages that he can accept in the circum- stances ; he believes that the employer will in 'the end be compelled to concede his demands. Arbitration would almost certainly result in terms that each party to the con- 1 88 INTRODUCTION TO ECONOMICS troversy would regard as unfair to itself. Consequently each party prefers to resort to a trial of strength. After the struggle has continued for some time, and each party has gained an insight into the real strength of the other, the necessity of mutual concession becomes apparent to every one concerned. Terms that would, at the outset, have been spurned by both parties can be accepted, though perhaps reluctantly, by both the employer and the employee. It is accordingly clear why a plan of purely voluntary arbitration is ineffective as a means for preventing strikes. Many of our states have created commissions or boards of arbitration with authority to settle industrial disputes upon the application of both contestants. The services of these officials are not often requested. In New Zealand employers and organized laborers are required by law to settle their disputes without recourse to strikes. The colony is divided into districts in each of which a board of conciliation exists which is authorized to inquire into all labor disputes with the purpose of effecting a settlement by mutual agreement. If the parties to the dispute cannot be brought to an agreement, the dispute is referred to the court of arbitration, which hears both sides and renders a decision which is binding. Under the New Zealand system the strike has been eliminated. Whether such a system would be satisfactory under the complex conditions of American industry is somewhat doubtful. In this country compulsory arbitration is regarded with disfavor both by employers and by organized labor. 17. The organization of labor modifies the operation of the competitive law of wages, but does not subvert that law. It has often been noted that in times of prosperity labor organizations are usually able to force a rise in wages ; in times of depression such organizations are unable to check a decline in wages. In times of prosperity the trend of wages, both of organized and of unorganized labor, is up- WAGES AS AFFECTED BY LABOR ORGANIZATION 189 ward ; in times of depression it is downward. In economic terms prosperity means an increase in the value product of labor, and the laws of competition compel the employers to raise wages accordingly. Depression means a reduction in the value product of labor, and hence results in a reduction in wages. But the competition of employers is never very acute, and for a long time they may fail to raise wages, although the general circumstances of industry justify higher wages. It is only as increased profits lead to an expansion of industrial operations and an increased demand for labor that the competition of employers takes the form of an increase in wages. Labor organization may force an ad- vance in wages long before the competition of employers would lead to the same result. By virtue of organization the laborer shares more promptly, and probably more liber- ally, in the increased productivity of industry than he would if he relied upon his individual bargaining power. While we must grant to labor organizations an impor- tant influence in maintaining a high level of wages, we must not forget that this influence may easily be over- estimated. Wages are higher in America than in England, not because our labor organizations are stronger than those of England, — for the reverse is true, — but because labor is more productive in this country than in England. Wages will remain at a high level in this country so long as the high productivity of labor is maintained; and no form of organization can long maintain wages in the face of declining productivity. 18. In so far as labor organizations tend to reduce the efficiency of labor, their ultimate effect upon wages is injurious. Labor organizations do not always confine themselves to the function of securing the highest pay for a given service ; in many cases they endeavor to reduce, as far as 1 90 INTRODUCTION TO ECONOMICS possible, the service rendered for a given wage. They en- deavor to reduce the number of hours in the working day ; they place checks upon the amount of work that each man may turn out in a day; they sometimes discourage the introduction of devices that increase the effectiveness of labor. These policies do not always result in a reduction in productivity. In the long run a laborer may be able to accompHsh more in an eight-hour day than in a ten-hour day. Excessive speed may quickly wear the laborer out, and render him incapable of performing tasks of a high degree of importance. So far as labor organization limita- tions lead to a conservation of the energies of the work- man, they increase the productivity of labor, in the long run, and make possible an advance in wages. Instances, however, are not lacking of restrictions that aim at compelling the employer to increase the number of men employed for the performance of a given amount of work. Many laborers cherish the illusion that society offers only a definite amount of employment, and that if one man increases the measure of his performance, he takes employment away from some other man. An entire laboring class may become infected with this fallacious view, and everywhere reduce efficiency to its lowest terms. Sooner or later employers find themselves unable to pay the existing rate of wages; if the organization is power- ful enough to prevent, for a time, a reduction in wages, employers reduce their working force; an "army of the unemployed " is created ; and in the end the organization breaks down under the competition of the laborers ex- cluded from employment. 19. Summary. The individual workman is often at a serious disadvantage in bargaining with his employer; hence wages will often be less than the worth of the laborer's services. This in- equality may be corrected by an organization of workmen, WAGES AS AFFECTED BY LABOR ORGANIZATION 191 all of whom present their demands upon the employer simultaneously. The trade union is an association composed of workmen employed in the same trade. When such an organization is formed an attempt is made to induce all the men practic- ing the trade to become members. After the organization gains practical control of a trade, it usually endeavors to limit the number of men admitted to the trade, in order to maintain a high level of wages. A trade union's position is greatly strengthened if it undertakes the relief of its members in time of sickness, accident, or unemployment. The principal function of trade union accumulations is the maintenance of the members of the union in time of strike. Each local union, further, is greatly strengthened by alliances with other unions in the same locality or in other parts of the country. The chief weapons of the trade union are the strike and the boycott. Where trade unions are strong they are often able to make satisfactory terms with their employers with- out resort to the strike. In many cases the terms of em- ployment are established by agreement between the em- ployers on the one hand and representatives of the trade union on the other. Disputes between employers and workmen are some- times settled by arbitration, without resort to a strike. In cases of prolonged struggles between employers and em- ployees, public opinion may compel a submission of the matters in dispute to arbitration. In New Zealand all disputes between employers and organized laborers must be settled by arbitration. Labor organizations increase general wages in so far as they prevent the employer from taking advantage of the weakness in bargaining of the individual workman, and in so far as they increase the efficiency of labor. Through restrictions upon output they sometimes reduce the prod- uctivity of labor and so tend to reduce general wages. CHAPTER XII THE PRODUCTIVITY OF CAPITAL 1. The term " capital goods " may be employed to designate objects of wealth that yield an income. Men who are engaged in business commonly divide their material possessions into two classes ; those that are held for the money income they yield, and those that are held for the immediate satisfaction they afford. The objects composing a merchant's stock in trade, his build- ings and fixtures, belong to the former class. The mer- chant's watch, the clothes he wears, the horse he rides for recreation, belong to the latter class. The former class we shall call " capital goods " ; the latter, " con- sumer's goods." When a man buys capital goods, he is commonly said to "invest money." When he buys con- sumer's goods, he is said to " spend money." The distinction, it is true, is not so easily drawn as might at first appear. Is a man's house to be classed with his capital goods .' The income that it affords is primarily one of satisfaction, like that afforded by a watch or a saddle horse. The possession of a house saves the pay- ment of rent, and to this extent adds to one's disposable income. Reflection will show, however, that goods yielding an income of direct satisfaction are normally distinguished by their owners from goods yielding a money return. The standards governing purchases of goods for business pur- poses are adequacy and sureness of return ; the standard governing purchases of goods serving personal uses is what one can afford. A home is seldom strictly a "business proposition," and for this reason may usually be 192 THE PRODUCTIVITY OF CAPITAL 193 excluded from the rank of capital goods. And the same thing is true of other goods yielding an income, not of money, but of satisfaction. 2. The permanent fund of productive wealth which capital goods represent is known as capital. The great majority of capital goods are perishable in their nature. The capital goods of a merchant, so far as they consist of merchandise, are destined in a very short time to pass into the hands of the merchant's customers, where they cease to be capital goods. So far as they consist of buildings and fixtures, they may endure a gener- ation or more; but in the end the buildings depreciate and the fixtures become antiquated. It would be next to impossible to find a business establishment which has the same capital goods it had a year ago. It is an easy matter to find an establishment which is said to have the same capital that it had a year ago. A merchant starts in business to-day with a capital of ^100,000 invested in building and stock. At the end of a year we ask him what his capital then is. Very likely it will still be ;? 100,000. Now, is this the same capital, or is it a new one ? The merchant certainly will say that it is the same capital — unless, of course, he has lost, in the course of the year, his original capital and has replaced it from some new source. But how can the capital be the same after the lapse of a year .? Nearly all the things that figured in the first inventory except the building, have been replaced, in the second inventory, by objects which may be of a quite different character. In the first inventory, perhaps, cheap grades of goods preponderate ; in the second these may be largely replaced by higher grades. However this may be, there can be no denying that the goods have changed, yet the merchant says that the capital is the same. Perhaps we are making ourselves unnecessary difficul- 194 INTRODUCTION TO ECONOMICS ties in our "endeavor to arrive at the merchant's meaning when he says that his capital remains the same even after most of the things originally composing it have left his pos- session. Possibly he means simply that he has as large a capital at one time as at another. Two things that are equal in magnitude are of course not the same thing, but we often speak of them as if they were. Yet if we reflect upon it, this does not appear to be what the business man means. Suppose that fire or flood had destroyed his store and stock, and that a rich relative, to set him on his feet again, had given him ^100,000 to re- place them. The merchant would not say that he was continuing in business with the same capital, although in magnitude it would be the same. Clearly, a business man thinks of his capital as something that is capable of remain- ing permanently the same although the goods that compose it are constantly changing. The popular definition of capital is a fund of productive wealth, which has the power of self -perpetuation. This definition we may accept as one of the simplest that have been proposed. 3. The permanence of capital depends upon the economic power of capital goods to replace their value either through sale or through assistance rendered in production. An enterpriser possessing $100,000 in cash proposes to establish a clothing store. The first thing he must do is to find a place where, he has reason to believe, the goods in which he proposes to deal will sell at a higher price than that which he must pay for them. This, of course, is comparatively easy to do. Goods, as they come from the factory, may in a physical sense be ready for use ; eco- nomically, however, much remains to be done before they can be placed where they will fulfil their ultimate purpose — the direct satisfaction of human wants. They must be conveyed to places where they are accessible to the con- sumer ; they must be so arranged that inspection is easy. THE PRODUCTIVITY OF CAPITAL 195 Expert clerks must be at hand to point out their good quali- ties and explain away their bad ones. This means that a considerable addition to the value of goods may be made after they have left the factory ; and this addition, properly speaking, is the product of the mercantile establishment. Each item of the stock normally sells at a price which will at least replace that item with one of equal value, to- gether with a surplus which will cover the cost of labor employed in handling it, and which will also make some con- tribution to the expense of keeping up the building. Any item which does not do this is carried at a loss ; and a busi- ness man who should continue to carry such items would see his capital diminish, and perhaps ultimately disappear. Some parts of the stock may afford a far larger surplus, and the aggregate income of the establishment may be much more than enough to keep stock and store intact, after paying for all human services directly employed. The nature of this excess of income above outlay we shall con- sider at a later point. For the present we are concerned primarily with the fact that the iirst demand upon the business is that each item shall maintain itself — i.e., through sale, reproduce itself together with auxiUary costs connected with it. It must now be clear how it is that a fund of capital persists. Each capital good, before it is sold or worn out, produces a sum of value that enables the owner of the good to purchase or make another good of the same character, which in its turn possesses the power of replacing itself by a successor of equal value. The capital goods of this year are, therefore, not merely the successors in time of those of last year, now mostly destroyed ; they are, economically, the offspring of the capital goods of the earlier period, and they have the same power of replacing themselves with other goods having the power of self-replacement. It is, of course, to be understood that this self -replace- 196 INTRODUCTION TO ECONOMICS ment is neither automatic nor inevitable. We may say that under certain conditions a particular capital good will add something to the total product of an industry, but not enough to keep itself in repair and replace itself when worn out. Under other conditions a capital good will just do this; under still other conditions a capital good will add to the product of an establishment not only enough for its own repair and replacement, but a surplus besides. Experience has taught enterprisers how to avoid the employment of capital goods that do not maintain themselves, and of those that do nothing more than this. Mistakes are of course sometimes made, but not so frequently as to invalidate the statement that capital goods, as a rule, reproduce them- selves economically through the values which they create. Intelligent action on the part of the owner of such goods is essential to the truth of this proposition ; but such action may generally be taken for granted. 4. What is capital to the individual may not be productive wealth from the point of view of society. A government may sell its bonds in order to raise funds to carry on a profitless war. The money raised is spent on powder and other munitions of war, which are soon destroyed. The wealth furnished by the purchasers of the bonds has simply been wasted, and cannot contribute to the payment of interest on the bonds or of the principal when it falls due. Interest and principal are, indeed, paid, but from the proceeds of taxation. The bondholder re- gards his bonds as capital ; they are wealth that yields an income, as he views the matter. But we can easily see that it is not the bonds that produce the income ; it is the labor and wealth employed in production that do this. If all the bonds were destroyed, the aggregate social income would be not in the least reduced. Capital of this kind may be called " purely acquisitive capital." It enables its holder to acquire an income ; it does THE PRODUCTIVITY OF CAPITAL 197 not produce an income. Capital which actually participates in production may be called " productive capital." The laws which we shall discuss in this chapter relate only to productive capital. 5. Productive capital may be embodied in goods that are the product of industry, or in goods that are the free gift of nature. A generation ago practically all economists restricted the term " capital " to productive wealth that has been pro- duced by industry, such as machines, stocks of materials, etc. Productive wealth, the origin of which cannot be traced to man's industry, was usually classified under the heading "natural agents," or simply under "land," since land is by far the most important good in this class. This terminology is still widely used by economists. In every- day language men speak of investing capital in land, as of investing capital in buildings or machinery. This usage will be followed in this book ; wherever it is necessary to distinguish between the two classes of productive wealth, we shall call the one artificial capital, the other natural capital. 6. Artificial capital originates in saving. It may at first appear that capital comes into existence whenever a productive instrument is created. Reflection shows, however, that this cannot be true, for a new capi- tal good often merely replaces a capital good worn out in the process of production, and may be said to embody the same capital. When a man employs, in producing a tool or a stock of the materials of production, time which he would otherwise have used to procure for himself the means of immediate enjoyment, he is dteating capital. These capital goods are not merely replacing capital goods previously existing ; they are a net addition to the stock of productive wealth at the command of society, which, like other capital goods, 198 INTRODUCTION TO ECONOMICS will for the future maintain themselves. When a man uses, to employ workmen in the production of capital goods, a part of his income which he would otherwise have spent for consumer's goods, he is causing new capi- tal to be created ; or, we may say, he is indirectly creat- ing capital. When he uses part of his income to buy capital goods that are already in existence, he is creating new capital by a still more indirect process. Thus if a man buys a threshing machine out of his savings, he places in the hands of the manufacturing company pur- chasing power with which the company can hire men to make another machine. The process of creating new capital may take a yet more roundabout course. The man who saves may invest his savings in a share of railway stock — which is nothing more than an evidence of owner- ship of capital goods already existing. The man who sells the share of stock may use the proceeds to buy a share in a manufacturing company. Here again it is evident that nothing new is created. The seller of the manufacturing stock may, however, use the money to buy a share in a new manufacturing company, and this company may em- ploy the proceeds to hire men to produce new capital goods for use in its business. Evidently it is the man who saved the money in the first instance who is the true creator of the capital thus added to the stock of society. Under present conditions the process of creating capi- tal is usually indirect. One man saves and other men produce the concrete capital goods in which the savings are invested. Of course it sometimes happens that such a complicated process fails to attain its proper end. One man may save i^ioo and buy a share of stock from another man, who uses the proceeds to meet his-current expenses. In this case no new capital is created. What has hap- pened is that a part of the existing fund of capital has changed hands. But normally men avoid, trenching upon THE PRODUCTIVITY OF CAPITAL 199 their capital ; accordingly, we are justified in regarding each act of saving as the creation of new capital. Just as it is improper to regard the creation of a capital good as in itself a creation of capital, so it is improper to regard the destruction of a capital good through ordinary use as the destruction of capital. For during its lifetime a capital good produces, as we have seen, a replacement fund. After the capital good has been destroyed, the capital exists under another form — as money or as other productive goods. 7. Natural capital increases with the development of society. Until the frontiersmen crossed the Appalachian Moun- tains, the land of the Mississippi Valley, with the timber upon it and the coal and other minerals beneath its surface, was scarcely to be classed as wealth at all. At best, it was potential wealth, not actual wealth. The settlement of the country and the development of means of communication transformed this potential wealth into an immense fund of productive wealth, or capital. Every increase in popula- tion, every improvement in methods of agricultural produc- tion, increases the importance, and with it the value, of the natural resources of a country. Measuring the capital rep- resented by these natural resources in terms of value, we see that it is constantly growing with the progress of society. The introduction of durum wheat raised the capi- tal value of lands in part of the arid belt from practically nothing to $\o an acre or more. The development of a spineless cactus may transform into productive wealth much of the desert land of the Southwest. New processes of steel manufacture have endowed iron ore deposits origi- nally worth very little with the character of highly produc- tive capital. 8. The productivity of a capital good can be ascertained only through experimentation. 200 INTRODUCTION TO ECONOMICS In order that a business man may conduct his business successfully, he must be able to form a fairly accurate esti- mate of the productivity of each class of capital goods which he uses. In the case of some classes of capital goods productivity is easily determined. Thus if one wishes to know how much a ton of fertilizer will produce, he has only to apply it to one of two equally productive acres of ground. The difference in the product of the two acres, less the cost of labor employed in applying the fertilizer, is a fair test of the productivity of a ton of ferti- lizer. We may term this the gross product of the capital good. After deducting from this product a sum equal to the cost of the fertilizer, whatever remains is the net prod- uct of the capital good. Some capital goods, however, do not readily admit of any such process of experimentation. Thus it might be difficult to determine the productivity of a field, apart from that of the seed, fertilizer, machinery, and labor employed in connection with it. Of course one acre might be left unfilled, and all the labor and auxiliary capital might be employed on the rest of the field. The total product would be less than it would have been had all the field been tilled ; and this diminution in product would indicate roughly the productivity of an acre of ground. This method would be clumsy and expensive; it is, moreover, unnecessary, since the productivity of labor and of auxiliary capital employed upon the land may be determined, for the most part, by the method already illustrated. Hence we may arrive at the gross product of the field by subtract- ing from the total product of the farm the values produced by the labor and the auxiliary capital. By subtracting from the gross product of the land a sum of value sufficient to replace the elements of fertility destroyed in the course of the year, we arrive at the net product of the land. 9. The net product of capital goods is commonly known as the product of capital. THE PRODUCTIVITY OF CAPITAL 201 Capital goods obviously must vary widely in their gross product. Some must be replaced daily, some yearly, some at the expiration of a decade or more ; a few classes, like land, are practically permanent. Until full replacement of goods used up has been made, a fund of productive wealth, or capital, cannot be said to be productive. A manufac- turer who finds that the receipts from a year's business are just sufficient to maintain intact his building, machinery, stock of material, and fuel, cannot say that his capital has added anything to his income. Capital which produces nothing is obviously not worth having ; and the mere fact that men make sacrifices to possess themselves of capital shows that, as a rule, capital may be expected to yield an income. When a man is considering whether he shall invest his capital in one kind of capital goods or in another, he may usually take the fact of self-replacement of goods for granted. The net productivity of capital goods, or, to use a simpler term, the product of capital, is the determining factor in his calculations. 10. The productivity of capital invested in any one class of goods is measured by the addition made to product by the last or marginal unit of capital thus invested. Other things equal, the productivity of capital in any one form, shrinks with increase of capital in that form. Let us suppose that a farmer possesses ten fields, vary- ing in natural fertility from a very high degree to a very low degree. And let us assume that $1000 worth of capital in the form of machinery, stock, etc., or auxihary capital, is necessary for the tillage of any one of the ten fields. If the farmer has control over only l^iooo worth of auxiliary capital, he will of course place it upon the best field. If from the gross product of that field he deducts the cost of labor employed in connection with it, together 202 INTRODUCTION TO ECONOMICS with a sum sufficient to cover the cost of upkeep of land and stock, he arrives at the net product of his agricultural capital — that is, of capital invested in both fields and stock. How much is due to the bare land, how much to the auxiUary capital? This it would be difficult to say, as neither would have produced anything without the other. Now let us suppose that the farmer gets possession of another j^iooo to invest in auxiUary capital. He may now till the field which is least inferior to the first one cultivated. The joint product of this field and of the ^looo of capital will be less than that of the first field because of the differ- ence in natural fertility. Shall we say that ^looo is more productive on one field than on the other ? The two units of capital are just alike ; the two fields are unlike. So it would seem to be more reasonable to assign the difference in productivity to the fields, not to the auxiliary capital. And this is what a practical man would do. If the first field produces ;?iooo and the second $900, he would say that at least ^100 of the product of the first is the product of the land, apart from that of the auxiHary capital. Is the $900 produced on the second field the product of the auxiHary capital alone ? In a physical sense, certainly not ; in an economic sense it is. This sum is what the addi- tional ;^iooo worth of auxiliary capital adds to the farmer's income ; $900 is what he would lose if he were deprived of either of his two units of capital. With another ^1000 the farmer is enabled to till a third field, which is somewhat less fertile than the second. Per- haps this field produces $800 net. If this is the case, the farmer will no longer regard the total product of the second field as the product of the auxiliary capital alone. This auxiliary capital is credited with no larger product than that of auxiliary capital on the third field — ^800. The other $100 now comes to be considered as the product of the land. At the same time, of course, a second ^100 is THE PRODUCTIVITY OF CAPITAL 203 subtracted from the product of auxiliary capital on the best grade of land. And as the farmer adds unit after unit of auxiliary capital and opens field after field to tillage, the productivity of auxiliary capital steadily shrinks and that of the better land as steadily increases. Perhaps the tenth field yields a net return of only ^100. In such case no one of the ten units of auxiliary capital can be said to yield more than this. The use of no one of the units is worth more to the farmer than ^100, for if any one were taken away from his control, he would replace it with the one employed in connection with the poorest field. In a grist mill the amount of capital which may be in- vested in machinery varies within wide limits. Once the mill is equipped with machinery, it would be difficult to increase greatly the amount of capital invested in machin- ery, since not more machines, but better ones, would here be the result of increased investment. We may, however, suppose that in determining upon the kind of equipment to be employed, an enterpriser goes through some such calculation as the following : — Given a building and a certain minimum of auxiliary capital invested in machinery — say $10,000, an annual return of j^ 10,000 may be secured. How much of this is the product of the building .■' how much is the product of the machinery .■" No one can say ; neither form of capital would produce anything without the other. Increase the capital in machinery by another ;^ 10,000 unit; the net return increases, we will say, to 1^15,000. The sum added by the second unit of auxiliary capital is ;^5ooo; as the two units of auxiliary capital are interchangeable, neither will be credited with more than this. Thus $5000 de- taches itself from the joint product of building and ma- chinery, and is credited to the building. Add another $10,000 unit in the form of machinery. The return in- creases to $17,000. $2000, then, is the product that can 204 INTRODUCTION TO ECONOMICS be credited to this unit of auxiliary capital, and no one of the three units will be credited with more than this. The building thus comes to be credited with ;^ii,ooo, the sum remaining after the product of the three units of auxiliary capital has been deducted. The principle involved in this example may be stated as follows : The productivity of any unit of capital em- bodied in a given class of capital goods is measured by the amount added to the aggregate net product of a business by that unit which it is least worth while to employ. 11. An increase in the capital of any establishment, at- tended by no parallel increase in labor, reduces the produc- tivity of capital and increases that of labor. Suppose that a farmer can command practically an in- definite amount of agricultural capital, whether in the form of land or in the form of movable capital goods, but that the amount of labor that he can secure is limited to ten men. With ;^5ooo invested partly in land, partly in movable capital goods, he may be able to produce 1^5000 net. We should here find difficulty in determining what part of this sum is produced by the labor, what part by the capital. An additional ^5000 of capital may increase the aggregate product of the business by $AfOOO. This sum we should properly ascribe to the new capital. And as this second unit of capital does not differ in any essen- tial respect from the unit at first employed, and as the removal of one unit of the two would have the same effect as the removal of the other, we may properly regard them as equally productive. The extra thousand appearing in connection with the first unit must then be credited to the other factor in production — the labor. If a third unit of capital increases the product of the business by ^3000, this amount will measure the importance of any one of the three units of capital. This is what the farmer would lose THE PRODUCTIVITY OF CAPITAL 205 if he were deprived of the use of any of the units. If a fifth unit adds only ^1000, the product assignable to any unit shrinks to that figure. And of course with each re- duction in the product assignable to capital, the product assignable to labor increases. 12. If the capital of an industry, or the capital of all soci- ety, increases, the productivity of capital declines. Up to the present point our study of the productivity of capital has been confined to the single business establish- ment. We must now consider whether similar principles are applicable to an industry in its entirety. The iron and steel industry of the United States may serve as our type. The capital at present engaged in the production of iron and steel may [be placed at about ^1,000,000,000, the number of men, at 250,000. Now let us suppose that without any revolutionary change in the demand for iron and steel the capital of the industry is increased by ;^ 100,000,000. What will be the effect upon the productivity of capital in the industry } It is fair to assume that before the increase in capital those branches of the industry promising the highest prof- its were already well developed ; that the richest deposits of ore and coking coal were already being exploited ; that the best manufacturing sites had been selected. To what use, then, will the new capital be put .■" Some of the enter- prisers may attempt to duplicate existing plant. This re- quires additional labor, and such labor is to be had only by inducing new men to enter the industry or by enticing men away from other iron manufacturers. In either case an advance in wages will follow, which will soon become gen- eral throughout the industry. In the old establishments as well as the new this will obviously reduce the share of the aggregate product which capital will receive. Again, the in- crease in iron and steel products thrown upon the market will lower prices. Thus, while the wages bill of an estab- 2o6 INTRODUCTION TO ECONOMICS lishment per unit of product will increase, the value of each unit of product will diminish. If all the new capital is used simply to duplicate existing plant, wages will rise to a decidedly higher level. The in- dustry will need one tenth more men than it has at present, and these will be slow to appear unless they are offered high wages. The fall in prices, moreover, will be a serious one, as the output will be increased about ten per cent. But when the prices of the staple products of an industry fall, it often pays to develop new branches of the industry that under earlier conditions were not profitable. When wages rise, it pays to introduce machinery that saves labor. Part of the new capital will be absorbed in these ways, and thus the productivity of capital will be prevented from sinking to as low a level as would otherwise be the case. The fact remains that the capital will be less productive after the increase than before it ; wages will be higher and prices lower. The increase in the aggregate capital of the industry, other things equal, will reduce the produc- tivity of each unit. The same principle is still more clearly applicable to in- dustrial society as a whole. The iron and steel industry can relieve the pressure upon its labor supply by inducing men to leave other industries. If the capital of society as a whole increases, a pressure is placed upon the labor sup- ply, for which there is no ready means of relief. The exist- ing capital is normally sufficient to provide every one who desires to work with the necessary appliances. If, then, the capital of all industries increases more rapidly than the population, the average capital employed with each laborer must increase. Such increase in capital must be embodied in improvements upon existing appliances, and, owing to the operation of the law of diminishing returns, will increase the product of industry less than an equal amount of capital does when the social fund is smaller. THE PRODUCTIVITY OF CAPITAL 207 13. The opening of new opportunities for investment may counteract the effect of increase in capital. There are of course conditions under which an increase in capital may not be followed by a reduction in the prod- uctivity of capital. If, for example, the labor supply in- creases as rapidly as the supply of capital, there is no reason why the productivity of capital should decline. Again, suppose that some practical method of draining extensive swampy regions or of irrigating vast tracts of arid land were discovered. The new capital might be absorbed by the opening of these fields. In the last century, though capital has increased enormously, there has been a corresponding enlargement of the field of in- vestment ; accordingly, the productivity of capital has de- clined little, if at all. 14. An increase in artificial capital, while reducing returns on that form of capital, is likely to increase the returns from natural capital. It has already been indicated that by placing more and more auxiliary capital upon a given area of land one must ordinarily reduce the productivity of auxiliary capital and increase the productivity of land. It will naturally be the aim of the business man to keep his capital uniformly pro- ductive ; if he has too much auxiliary capital he will en- deavor to get more land, and vice versa. He will ask himself: Would it pay me better to invest my next ;^iooo in land or in auxiliary capital .■• And he will continue to direct his investments toward whichever class of capital goods is for the moment the more productive, until the superiority of that class disappears. Similarly, an entire industry may expand with more or less symmetry, distributing its new capital among the various classes of capital goods of which it stands in need. If the beet sugar industry expands, not only are more factories constructed, more machinery for the cultivation 2o8 INTRODUCTION TO ECONOMICS of beets purchased, but more land is drawn into the service of the industry. This land is, of course, taken away from other industries — wheat culture, dairying, etc. When the social fund of capital increases, on the other hand, it is not possible for a symmetrical increase in all classes of capital to take place. The land, we may sup- pose, is already almost all in use ; the best mines are opened ; the most available courses for railways and canals are already occupied. These things the new capital can- not duplicate; their importance, therefore, steadily increases. On the other hand, steel rails, locomotives, factory build- ings and thousands of other forms of capital goods are readily duplicated. The marginal productivity of capital in these forms naturally declines, and a larger part of the product is left to be divided between labor and natural capital. 15. When the return to natural capital varies from the return to artificial capital, equalization is commonly brought about by revaluation. When, however, we speak of the productivity of capital in general we usually take as our test the productivity of new capital — and this, we see, is practically the capital in goods which are capable of duplication. And instead of thinking of the old capital in nonduplicable goods as more than normally productive, we are likely to revalue the capital in such forms. Ten years ago, let us say, a five- acre lot gave as large a net product as a threshing machine. To-day the same piece of land yields twice as large a net return as a threshing machine equal in value to the one of ten years ago. We might say that the capital in land has doubled in productivity. But it is more usual to say that to-day the land represents twice as much capital as the threshing machine, although it represented no more capital than the threshing machine ten years ago. By a similar process of revaluation, the productivity of all capital which THE PRODUCTIVITY OF CAPITAL 209 is abnormally productive is reduced to the general level. This process of revaluation will receive our further atten- tion in the next chapter. 16. The productivity of artificial capital varies at any particular time from industry to industry, but tends con- stantly toward a uniform level. Even capital which is embodied in capital goods that are capable of reduplication may at any given time vary widely in productivity from establishment to establishment, or from industry to industry. It is only by experimentation that the actual productivity of capital can be determined, and owing to the changing character of modern industry the process of experimentation must go on without ceasing. Accordingly, there are always chances of mistakes in invest- ments. A cotton manufacturer may overestimate the prod- uctivity of capital in a given type of loom ; after purchasing and installing the machine he must content himself with what it will produce, even though he knows that the same amount of capital would in another form yield a far higher return. Cotton manufacturers as a class may overestimate the future demand for cotton goods, and so may be led to invest heavily in buildings and machinery which prove in- capable of returning the normal rate of interest on capital. At the same time the shoe industry may be undersupplied with capital ; for a time, at least, every one hundred dollars invested in the industry may yield an abnormally high return. Such disparity in the productivity of capital in the two industries would, however, tend to disappear. The capital invested in new cotton mills would, of course, be fixed in the industry for a long period of time. But in the industry as a whole there are always some mills that are about to be dis- mantled, having reached the limit of their useful existence. These mills have presumably earned in the past a sum suffi- cient to replace themselves with new mills of a value equal 2IO INTRODUCTION TO ECONOMICS to that of the original ones. If the cotton industry is suf- fering from a depression while the shoe industry is highly prosperous, the replacement fund will be diverted to the latter industry. Through the reduction of capital in the cotton industry the productivity of capital in that field is increased ; through the increase of capital in the shoe indus- try the productivity of capital is reduced in that industry. It is easy to see that if this process continues for any length of time the original disparity in productivity must disappear. The equalization of productivity is hastened by the dis- position of new accumulations of capital. The fund of capital, under modern conditions, is constantly growing in magnitude ; consequently industries are, as a rule, expand- ing. The new capital naturally seeks the most productive fields. If, therefore, the rate of return in the cotton indus- try is abnormally low while that in the shoe industry is abnormally high, the new capital will avoid the former industry and seek investment in the latter. The influx of new capital into the shoe industry reduces productivity there, until at last capital is no more productive in the one industry than in the other. When this point has been reached, further additions to the supply of capital are divided impartially between the two industries, reducing productivity uniformly. It is, of course, possible that the productivity of capital in the two industries may never be absolutely equal. While the tide of new capital is setting steadily toward the shoe industry, a new demand for cotton goods or a new method of manufacture may appear and raise the productivity of capital in the cotton industry above that of the shoe industry. Some time will elapse before the change in the relative positions of the two industries is generally known ; in the meantime the flow of new capi- tal into the shoe industry continues. Eventually the new THE PRODUCTIVITY OF CAPITAL 211 capital is diverted to the cotton industry ; it may continue to flow in that direction after the cotton industry has lost its relative superiority. We can only say that a tendency toward equalization of productivity exists ; not that equali- zation is ever exactly realized. 17. Any barrier preventing the free flow of capital into an industry makes possible an abnormally high retiim on capital in that industry. It is, of course, to be remembered that the productivity of capital is not the only thing that an investor takes into account in deciding in what industry he shall invest his savings. In some investments the danger of losing all or a part of the capital invested is great. Capital employed in developing the asphalt deposits of Venezuela may be highly productive ; but there is a chance that the existing government of Venezuela, from which title to the asphalt deposits is derived, may be overturned, and a new govern- ment may confiscate the capital invested in the business. Capital invested in street railways may be very productive. But if cities do not follow a consistent policy in chartering new companies, it is possible that at any time rival lines may be established on parallel streets and, if unable to make large returns themselves, they may, nevertheless, reduce the return on capital invested in the original lines to almost nothing. The capital still remains in the pos- session of the investor, but it is "dead capital." A mer- chant's capital, invested in a fancy fabric, may promise high returns; but a sudden change in fashion may force the merchant to sell the goods at a price which not only yields no return on the capital invested, but which entails an actual impairment of the capital fund itself. Some risk, it is plain, inheres in every business; in some fields of investment, however, the risk is so small as to be negligible, while in other fields no prudent investor can disregard it. Other things equal, the vast majority of 212 INTRODUCTION TO ECONOMICS investors will prefer to invest in the safer fields. A dis- proportionately large share of the capital of society, there- fore, seeks the safer investments, and as a result the productivity of capital in such investments falls below the rate of return to capital in the more hazardous investments. And thus it is that there appears a regular variation in the productivity of capital corresponding with variations in risk. It is, of course, clear that it is not actual risk, but esti- mated risk, that affects the distribution and hence the prod- uctivity of capital. It is quite possible that the risk of los- ing capital invested in banking in Texas is less than the risk of losing capital similarly invested in New York. But if most of the persons having capital to invest mistakenly believe that the reverse is true, a disproportionately large part of the flow of new capital will enter the New York in- vestment field and reduce the productivity of capital there below the level prevailing in Texas. In an earlier chapter we saw that risk affects wages only in so far as it affects the distribution of labor ; further, that if enough reckless workmen can be found to man the dangerous trades, risk will not affect wages at all. Exactly the same thing is true of capital. If there were enough investors who always chose the more remunerative employ- ments for capital, regardless of risk, the hazardous fields would soon be so well supplied with capital that they would yield no higher returns than the safer ones. As a rule, how- ever, capital is far more timid in assuming risks than labor. It is therefore more anomalous to find capital in a haz- ardous field yielding only normal returns than it is to find workmen in dangerous occupations receiving only normal wages. Risk, then, may be regarded as a barrier which pre- vents capital from flowing freely into some of the more productive fields. It is of course not the only natural bar- THE PRODUCTIVITY OF CAPITAL 213 rier affecting the flow of capital. If a particular industry is subject to the universal moral disapproval of a community, most capitalists will refuse to invest in it. Those who are unscrupulous enough to do so may enjoy the high returns that flow from an industry that is under-supplied with capi- tal. Thus, high returns are often obtained from capital invested in gambling dens and opium "joints." It is, of course, possible that the investment institutions of a country may be of such a nature that a man can hold stock in dis- reputable enterprises without the knowledge of his associ- ates, and that investors who have no personal scruples are numerous. Under these conditions the productivity of capi- tal in such ventures will eventually fall to the normal level. 18. Summary. Material goods which serve as means of production are known as capital goods. In the normal course of industry, each capital good, before it is worn out, makes at least a sufficient addition to product to replace itself with an equally valuable capital good; and under normal conditions, each capital good, when worn out, is actually replaced. Capital goods may therefore be regarded as a self-perpetuating fund of productive wealth. This fund is termed productive capital ; it is to be distinguished from those forms of wealth, also commonly termed capital, which add nothing to the product of society, although they enable their owners to secure an income. Under certain conditions, it is necessary to distinguish between that productive capital which is the product of industry and that which is the free gift of na- ture. The former may be termed artificial, the latter natural, capital. The productivity of each capital good can be ascer- tained only through experimentation. A distinction must be made between the gross product of a capital good — the total value product originating in it — and its net product — the sum of value remaining after deduction of the ex- 214 INTRODUCTION TO ECONOMICS pense of repairs or replacement. The net product of capi- tal goods may be regarded as the product of the fund of such goods, or capital. The productivity of capital invested in any class of goods is determined by the addition to net product made by those goods of the class that perform the least important func- tions. Every increase in the amount of capital invested in a given class of goods tends to reduce the productivity of each unit of capital in that class, and to raise the produc- tivity of capital invested in other classes of goods, as well as the productivity of labor. Natural capital often fails to increase as rapidly as artificial capital; consequently, for long periods of time the productivity of natural capital goods tends to increase, while that of artificial capital goods tends to decline. Equalization of return to the two classes of capital can be brought about only through revaluation of the natural capital goods. The earnings of capital in the different classes of artificial capital goods tend, under competition, toward a uniform level; in many cases, how- ever, barriers preventing the free flow of capital keep the earnings of capital in one field permanently higher than in another. CHAPTER XIII RENT, INTEREST, AND CAPITALIZATION 1. Rent, in everyday speech, is a payment for the tempo- rary use of durable goods. In popular usage the term " rent " is applied to any pay- ment which one person makes to another for the tem- porary use of a concrete good or group of goods. Thus rent may be paid for the use of a farm, a house, a piano, a square yard of advertising space on a bill board. In the nature of the case, only those things can be rented which remain practically intact through the period of use. One never rents a bin of coal or a stock of merchandise. Nor does one ever rent goods which can serve their purpose only by entering into permanent combination with other goods. No one would think of trying to rent steel beams to be used in the construction of his house. The more nearly indestructible a good is, and the more perfectly it yields up its services without losing its identity, the better is it adapted to the renting contract. Thus a field, being practically indestructible, may very well be rented for a period of years, although if its cultivation requires the in- corporation of a large amount of auxiliary capital in the soil, in the form of drains or irrigation ditches, the field and the auxiliary capital must usually be rented together. A piano, which is much more likely to be injured, neverthe- less lends itself fairly well to the renting contract because no other capital good enters into permanent combination with it in use. 2. The term rent has been comm,only used by economists to designate income arising from natural agents. In the classical economic terminology, rent included all income from permanent natural agents, whether these 215 2i6 INTRODUCTION TO ECONOMICS agents were leased or employed in production by their owners. A field, a building site, or a waterfall, it was said, yields rent. Incomes from houses, machines, and other reproducible goods were called interest on capital. The word rent is used in the classical sense by a large number of our living economists. While the term will be given a different meaning in this book, we shall recognize rent in the traditional sense under the name ground rent. 3. The term rent in its broadest sense includes the prod- ucts of all capital goods, whether retited by the enterpriser or owned by him. If a man owns and manages a farm which he could let at a rental of ^looo, we may say that $1000 out of his income is really the rent of his farm. True, he does not pay this sum to any one ; but neither does he pay any one wages for the labor which he himself performs. It would be absurd, however, to say that a man earns no wages when he is work- ing for himself. As employer he pays himself wages as workman. In like manner, the man who cultivates his own field may be thought of as paying rent, as cultivator, to him- self, as landlord. So, if an ocean transportation company owns and sails a ship which it could let for ^5000 a year, we may regard $5000 out of the proceeds of the company's business as the rent of this particular ship. In this broad sense of the term, rent may be defined as that part of the proceeds of a business which is economically due to a par- ticular capital good. It is the economic product of a capi- tal good, regarded as a lump sum. And as even the most perishable of capital goods yield a product which may be measured in this way, we may strain the ordinary meaning of the term rent so as to include the concrete products of all capital goods whatsoever. 4. For practical reasons, a study of rent may best be con- fined to the products of goods that have a high degree of permanence. RENT, INTEREST, AND CAPITALIZATION 217 While the term rent is, as has been said, properly ap- plied to the product of any concrete capital good, we shall in this chapter confine our study to the rent of those classes of goods that are of such a nature as to permit the trans- fer of their uses under renting contracts. The distinguish- ing characteristic of this class of goods is that the capital embodied in them is iixed there, for a considerable period of time at least. It takes perhaps ten years before the capi- tal invested in a boat can migrate to some industry upon the dry land. The capital embodied in a well-built house may be fixed there for fifty years ; and the capital invested in a field, in a tunnel, or in an excavation must remain where it is forever. It is true that you may take your capital out of a field ; this you do when you sell it. But what you really do when you sell the field is to transfer to another person your claim to the capital it represents. The capital in the field is the same after the transaction as it was before it. Such permanently invested capital may be contrasted with the capital invested in transitory forms, as coal, raw materials, merchants' stocks. The capital invested in these forms returns to its owner in a relatively short time in the form of purchasing power, and may be reinvested in any one out of a thousand different classes of capital goods. The return to such transitory goods is most conveniently calculated as a percentage return to the capital invested in them. It is natural to think of the return to a farm or a building as a certain sum of money, or a rent. One may, of course, translate the rent into terms of interest on the capi- tal invested in the farm or building. On the other hand, it is natural to think of the return to a merchant's stock in trade as interest on the capital invested in the stock, al- though it would be quite possible to arrive at the returns to the stock by adding together the net products of all the capital goods whose services have been used. 5. Gross rent is the total product of a capital good ; net 2i8 INTRODUCTION TO ECONOMICS rent is whatever remains of the product after deductions have been made for the repair and replacement of the capital good. Net rent is identical with interest. We must be careful to distinguish between the total prod- uct of a capital good, or its gross rent, and that part of the product remaining after the cost of depreciation of the capital good has been deducted, or net rent. To arrive at the net rent of a house we must deduct from the gross rent a sum sufficient to meet the cost of repairs, together with a year's proper contribution to a fund for the replacement of the house when it shall cease to be habitable. Even the payment for the use of a field is a gross rent. The field wears out — that is, it loses through cropping a part of its original or acquired fertility. The owner of the field must, therefore, set aside a part of the product of the land to re- store the fertility of the soil. It will be noted that net rent, in the sense in which the term is used here, is nothing but interest under another form. We will say that a house yields a net rent of ^looo. This ^looo is the sum of interest on the capital invested in the house. If this capital is $io,ooo, each ^loo of it yields an income of ^lo. In other words, the rate of interest is ten per cent. In general, if we reduce the rent of a group of capital goods to a percentage of the capital embodied in them, what we have is interest on this capital. 6. The rent of the permanent goods used in an enterprise is most conveniently treated as a residue remaining after the wages of labor, charges for the use of capital in perishable forms, and the cost of materials and other perishable goods have been deducted from the total product of the enterprise. In the last chapter we saw that there are two ways of arriving at the product of a concrete capital good, or its rent. One way is to withdraw the capital good from the productive combination into which it enters, noting the RENT, INTEREST, AND CAPITALIZATION 219 shrinkage in product that follows. The other way is to deduct from the gross receipts from a group of several goods the shares (if these can be independently ascertained) that are due to all of the goods except one. What is left is of course the product or rent of the remaining good. Either method may be employed in ascertaining the rent of many capital goods ; but the latter method is most fre- quently employed in the case of goods that lend themselves readily to the renting contract. If one wishes to rent a steam thresher, for example, he will first of all inquire what the gross earnings from the operation of the machine are likely to be. Perhaps such earnings will average ^20 a day. In order to operate the thresher, it is, of course, necessary to employ labor and auxiliary capital goods — as coal and machine oil — in connection with it. The labor must be paid for at the prevailing rate of wages ; coal and oil must be paid for at the market price. There are accordingly defi- nite sums that must be deducted from the gross receipts from the operation of the machine. Whatever is left after these charges have been met — possibly $10 — is the gross rent of the machine for the day. In the foregoing example the cost of labor, of coal, and of^ oil were regarded as preferred charges upon the earnings of the enterprise, and this indeed they are. The operator of the threshing machine must pay at least the prevailing rate of wages, or he cannot get labor to run the machine. Similarly, he must pay the market price of coal. Labor and coal have a multitude of uses outside of the business of threshing ; if not properly rewarded in that busi- ness they go elsewhere. The machine, on the other hand, cannot seek other employment. It is committed to a par- ticular function ; consequently it cannot enforce any claim for a specific remuneration. The machine is, as it were, a residuary claimant ; and this is more or less true of most of the capital goods that are actually rented. Economists 220 INTRODUCTION TO ECONOMICS therefore find it convenient to treat rent as though it were always determined in this way. A steamship building company, not having sufficient orders on hand, launches a freighter on its own account, trusting to the chance that some ocean transportation com- pany will be ready to pay a fair rental for its use. What will determine the rent that the transportation company will offer to pay.-" The managers of that company can probably estimate pretty accurately what the gross receipts from a year's operation of such a ship would be. Let us say that the estimated gross receipts are $35,000. From this sum must be deducted the wages of officers and men, $7000; charges for pilotage, harbor dues, etc., $1000; the cost of coal and provisions, $10,000; miscellaneous expenses, $1000. Nor is this quite all. The $10,000 in- vested in coal and provisions — supposing that the trans- portation company must purchase the whole amount at the beginning of the year — is capital that would in any other field earn $500 interest. This sum must therefore be added to the preferred charges of operating the ship. The $15,500 remaining out of the estimated gross receipts is the maximum rent that the transportation company can pay for the use of the ship. This sum, the gross rent of the ship, includes, however, payment for the depreciation of the ship through one year's use. If this amounts to $10,000, we have remaining the sum of $5500 as the net rent. Similarly, the gross rent of a farm is found by deducting from gross receipts a sum that is sufficient to pay the wages of all labor employed in cultivating it ; to replace all capi- tal goods used up ; to keep up the efficiency of all stock and machinery, together with interest at the prevaihng rate on the capital invested in such movable capital goods. To arrive at the net rent we must deduct from the gross rent thus determined whatever may be necessary to keep RENT, INTEREST, AND CAPITALIZATION 221 buildings, fences, etc., in repair, and to restore to the soil any elements of fertility that have been destroyed in the year's cropping. 7. The rent of any one out of a number of classes of goods united in a permanent combination m,ay be ascertained by comparison with other productive combinations in which some, but not all, classes are represented. In the cases that have been given the rent-yielding ob- ject is a group of capital goods, more or less securely bound together in use. The farm, for example, may be analyzed into several distinct factors. One factor is the bare land ; another factor consists of improvements merged in the soil, as drains or irrigation ditches ; a third factor consists of farm buildings, fences, tree plantations, etc. Some part of the rent must be ascribable to each one of these factors. The productivity of such a factor cannot be found by withdrawing it ; nor can it be found by treating it as a residue, after ascertaining the shares of the other factors combined with it, for these shares cannot be ascer- tained directly. There remains the method of compari- sons. How much more will a well-drained field yield than another field in the vicinity, of apparently equal natural fertility, but without drains .'' By such comparisons it is usually possible to tell pretty nearly what each factor in a permanent combination of capital goods is producing. One may distinguish in this way between the rent paid for a city house and the rent paid for the ground it stands on, although the two rents usually make parts of a single payment. Find an equally spacious and costly house in a suburb, where a building lot is to be had for practically nothing. The difference in the rent of the two houses is a fairly accurate measure of the rent of the city lot. 8. The rent of an artificial capital good tends, in the long run, to equal interest, at the current rate, on the cost of du- plicating the capital good. 2 22 INTRODUCTION TO ECONOMICS The rent of a ship, a building, or a machine, may, as we have seen, be ascertained, in the first instance, by subtract- ing from the gross receipts arising from its operation a sum covering all other expenses connected with its use. The value of such a rent-bearing object does not immediately affect the amount of rent it yields. A ship that yields a net surplus of 1^5000 above operating expenses may be worth ^50,000 or ^100,000. The value of the ship has nothing to do with the amount of rent that its owner will receive in the immediate future. But a ship is a capital good that requires periodic renewal. Out of lOOO ships sailing the ocean to-day probably fifty are near the end of their eco- nomic existence, and will have to be replaced by new ships if the existing tonnage is to be maintained. Now, if the rent of ships happens to be so low as not to pay the ordinary rate of interest on the capital represented by the cost of building them, no new ships will be built to take the places of those that are no longer seaworthy. The aggregate tonnage will thus be reduced ; freights will be advanced until the rent of ships rises to a figure which affords a normal return to shipping capital. If, on the other hand, the rent of ships represents an abnormally high return to capital, more ships will be built, and freights will decUne until the rent of ships is only sufficient to pay a fair rate of interest on the capital invested in them. And this is in general true of the rents of all capital goods re- quiring periodic renewal. For a time the rent may be too high or too low to afford just a normal return to the capi- tal invested in such goods. In the long run, however, the rent is controlled by the prevailing rate of interest. 9. The rent of land is dependent, in large measure, tipon the rate of wages and of interest on auxiliary capital. We have seen how it is possible to distinguish the rent of the bare land from the rent of the improvements fixed in it. The rent of land as such is of more practical impor- RENT, INTEREST, AND CAPITALIZATION 223 tance than the rent of any other class of capital goods, as land is more ■ frequently held under lease than any other class of capital goods. For this reason, and because land rent displays certain peculiar characteristics, it is worth while to devote especial attention to a study of the laws determining it. Let us assume that the construction of a railway throws open to exploitation a large section of territory in the Brit- ish Northwest, and that all the land is at once bought up by wealthy persons who intend to hold it permanently, parceling it out in tracts suitable for tenant farmers. We shall further assume that the owners of the land leave its equipment with auxiliary capital goods entirely to the ten- ants, and that the deterioration of the land is so slight as to be negligible. Whatever the tenant can be made to pay, under these conditions, is practically the rent of the bare land. In making up his bid the tenant will have to estimate, on the one hand, the gross receipts from the land which he expects to occupy, and on the other hand, all expenses of cultivation, including the wages of all labor employed, his own as well as that of hired hands; interest on the auxiliary capital which he furnishes, whether his own or borrowed capital ; and a sum sufificient to replace or repair capital goods destroyed or impaired through use. Let us suppose that all these items of expense amount to $1000. If the tenant has reason to believe that one year with another the gross receipts from the farm will be only ;^iooo he will pay nothing at all to the owner of the land for its use. If on the other hand he believes that the gross receipts will be ^2000 he will be prepared to pay a rent of $1000. It is obvious that what the tenant can afford to pay for the use of the land depends, in large measure, upon the rates at which he must reckon the wages of labor and inter- est on auxiliary capital. If these rates are high, the deduc- 2 24 INTRODUCTION TO ECONOMICS tions from gross receipts to be made in calculating rent will be large. Accordingly, in order to arrive at the forces de- termining the rent of land in the section which we are study- ing, we must examine the influences affecting the local rates of wages and interest. Land in the Canadian Northwest, as in every other part of the world, varies in natural fertility and in accessibility. If the supply of auxiliary capital and of labor is very small, only the most fertile and most accessible lands will be cultivated. The owners of slightly poorer or slightly less accessible lands will of course derive no revenue from them ; they could afford to let such lands for a nominal rent. On these lands, then, labor and auxiliary capital are free to divide between them whatever th'ey can produce. The labor and auxiliary capital employed on the better land can demand at least as much for themselves ; if this is refused, they will migrate to the unoccupied fields. Now let us suppose that a new body of laborers, bring- ing with them the appropriate auxiliary capital, enter the region. These occupy the lands which in fertility and acces- sibility are least inferior to those first cultivated. If after this accession of labor and capital any one is dissatisfied with wages on the better lands, he may, as before, migrate to land still remaining unoccupied. But the unoccupied land is now more remote and less fertile than was that exist- ing before the accession of the new labor and capital, and the product of labor and capital on such lands will be less. The cultivator of the better grade of land will therefore not have to pay so much for either factor as before. A larger share of his gross receipts may therefore be paid out in rent. And with every increase in the labor and auxiliary capital of the community, remoter and less fertile lands are brought under cultivation, with consequent decline in wages and in interest on auxiliary capital, and increase in the rent of all the better grades of land. At any particular time we RENT, INTEREST, AND CAPITALIZATION 225 may say that in this community the wages of labor and the interest on auxiliary capital are determined, respectively, by the productivity of labor and of auxiliary capital on the poorest land actually cultivated. This is of course only a special instance of the law stated in earlier chapters, that wages and interest are determined by marginal prod- uctivity. From the fact that when labor and capital flow into a new region the rent of land steadily rises, it is often assumed that the aggregate of land rents is constantly increasing. But it is to be borne in mind that when labor and capital are drawn into a new region, the older communities may come to be less fully supplied than before. And this would in- crease the shares of labor and of auxiliary capital in those communities, and reduce the share that is assigned to land. The increase in rents in America, in the last half century, has in some measure been offset by a decline in rents in Europe. If, however, population and capital in reproducible forms continue to increase, without any corresponding increase in the amount of land accessible to the cultivator, and without improvements that increase the general productivity of labor and capital, the aggregate of land rent must increase. 10. A rise in the prices of agricultural products usually raises the rent of land. In the foregoing example we have assumed that the value of the product of a farm remains fixed, while the rates of wages and interest vary. Let us now see what would be the effect on rent of an increase in the value of the product — which we shall assume to be wheat. Such an increase might be brought about by a reduction in the cost of transportation. For the local price of wheat is practi- cally equal to the price in England, the great wheat market of the world, less the cost of transporting the wheat thither. If the cost of transportation is reduced five cents a bushel, the local price of wheat will rise five cents a bushel. 226 INTRODUCTION TO ECONOMICS If the growers of wheat are forced to rely upon the local supplies of labor and capital, the effect of the rise in the price of wheat will be an increase in wages of labor and interest on auxiUary capital ; the rent of land will scarcely be affected. For under the conditions assumed, wages and interest are determined by the value of the product of these agents on the poorest lands in the com- munity actually in use. The value of this product will be increased by the rise in the price of wheat ; hence wages and interest will ns6 throughout the territory. The cultivator will have greater gross receipts, but he will have greater deductions to make under the heads of wages and interest. There is no reason why the surplus, or land rent, should rise. If, on the other hand, close relations have been estab- lished between this region and the rest of the world, so that wages and interest are determined by the general in- fluences prevailing in society, practically the whole of the advance in wheat prices will be applied to rent. For sup- pose that at first wages and interest are raised above the general level. Additional labor and capital will flow into the region ; competition will arise for employment on the better lands, or worse lands will be put under cultivation. Thus the marginal productivity of labor and of auxiliary capital will be reduced and the rent of land will increase, until labor and capital are rewarded no better than they were before — that is, until land rent has absorbed the entire benefit of the increase in price. It is true that the withdrawal of labor and capital from the general field that this movement implies will tend to raise the rewards of these agents slightly. But this influence will be hardly perceptible. We can now understand what it is that forces up agri- cultural rents in the vicinity of a growing city. The value of the gross product of a given area is constantly increas- RENT, INTEREST, AND CAPITALIZATION 227 ing, as a result of increased demand, while the charges to be deducted, wages and interest on capital in reproducible forms, are controlled by general laws which are affected only slightly, if at all, by the growth of this particular city. We can explain in the same way the rise of rent of city lots. The aggregate profits from the business that may be transacted on a given ground space increase with the growth of a city, and as wages and interest on reproducible capital do not increase in equal degree, a larger surplus is left for the owner of the land. In the same way the rent of a railway or a canal in a rapidly developing region steadily increases. The railway or canal is a capital good which cannot readily be reproduced. Accordingly, if the aggregate business to be carried on increases, an increas- ing share of the value product of the business will take the form of rent on the irreproducible elements. 11. Growth of population and increase in accumulations tend to raise ground rents generally. In all the cases that we have examined, an important factor in raising rents of land and similar capital goods is the influx, or possibility of influx, of capital and labor from the general field. If we view society as a whole, there is, of course, no possibility of a similar influx of labor and capital from outside regions. Nothing can transfer to the owners of land the benefits of increased value product ex- cept increase in the aggregate supply of labor and auxil- iary capital. If these agents remain stationary in quantity, while the progress of improvements raises the productivity of the units that are placed at the greatest disadvantage — that is, if general wages and interest rise — it is obvious that the rent of land may fall. So also if population and auxiliary capital decrease in amount. If, on the other hand, labor and auxiliary capital increase so rapidly that wages and the interest on such capital fall, land rents must in general rise. It is, of course, possible that increase of 228 INTRODUCTION TO ECONOMICS capital and of labor may be attended by such great im- provements in methods of production that wages, interest on reproducible capital goods, and land rent will all in- crease. This has been more or less true of the economic development of the last century. 12. The process of computing the amount of capital in a good from its 7iet rent is termed capitalization. Given the net rent of a capital good and the current rate of interest on capital, it is an easy matter to ascertain the amount of capital invested in the good. Multiply the sum representing the usual net rent by the quotient arrived at by dividing loo by the number representing the rate of interest. If the net rent of a farm is $2500 and the current rate of interest is five per cent, the capital value of the farm is J-|^ x 2500, or $50,000. This process of com- puting the capital through the net rent is known as capitali- zation. If a building earns $10,000 a year, and there is good reason for believing that it will continue to earn the same net rent indefinitely, the simplest way of ascertaining how much capital is invested in the building is to find how large a sum of capital, in general investments, is required to earn an equal sum. If the general rate of interest is ten per cent, this sum will be $100,000. If the rate of interest is five per cent, the sum will be $200,000. In the one case the rent is capitalized at ten per cent, in the other case at five per cent. 13. The amount of capital in a reproducible capital good is determined by its cost of duplication. The amount of capital in capital goods that cannot be replaced is determined by the capitalization of their rent. In the case of reproducible capital goods, the net rent alone is no suiificient indication of capital value. The cost of producing similar goods must be taken into account; indeed, this is by far the more important element in the computation. A ship, for example, may yield a net rent RENT, INTEREST, AND CAPITALIZATION 229 of ;? 10,000 at a time when the current rate of interest is five per cent. It would, however, be a reckless business man who would assume, from these data, that the ship represents a capital of ;^200,ooo, and that he could afford to pay that sum for it. If a similar ship can be built for ^100,000, this sum is the true measure of the capital invested. The net rent of ^10,000 merely indicates that capital in ships is, for the time, highly productive. Soon the supply of ships will, doubtless, be increased and the net rent will fall to about ^5000. It may be a year before the decline will take place ; in such case the buyer of a ship already afloat can afford to ■ pay about $105,000 for it. This sum may be analyzed into two parts; $100,000 for the capital in the ship, and $5000 for the transfer of the extra productivity of the ship through one year. If several years must elapse before the net rent of ships falls, the second element in the price of the ship will be placed at a higher figure ; and if in some way this extra productivity could be made perpetual-^ if the ship, worth originally $100,000, could be made to yield indefi- nitely $5000 in addition to the normal earnings of the capi- tal invested in it — the buyer could afford to pay as much for this extra product as for the original capital. That is, he would arrive at the value of the ship, not through a com- putation of its cost of production, but through a capitaliza- tion of its entire net rent. Now, a tract of land is a capital good in a situation analogous to that of the ship in our hypothetical case. The capital invested in the land, in the first instance, may have been nothing at all. But if the land yields a net rent of $5000 a year, that fact is the only one that buyer or seller will need to consider. For it is not possible that the supply of similar pieces of land at the command of society will be so increased that the net rent will shrink to zero, as would be the case with a reproducible good originally costing nothing. Because,of the natural limitation upon the supply 230 INTRODUCTION TO ECONOMICS of land, there is good reason for supposing that the existing rent will continue to be paid indefinitely. The right to re- ceive the ^5000 land rent for all time is therefore worth just as much as the possession of a capital in reproducible forms yielding j^sooo interest annually. If capital in re- producible goods yields, as a rule, ten per cent, the rent of the land will be capitalized at $50,000; if the current rate on such capital is only five per cent, the rent will be capi- talized at $100,000. Shall we say that a tract of land that yields $5000 rent, and is capitalized at $100,000, is really a capital of $100,000, or shall we say that the real capital in the land is only the sum originally employed to clear it and render it fit for economic use ? If we adopt the former mode of expression, we shall regard the capital in the land as no more productive than capital in any other form. If we adopt the latter mode of expression, we shall regard the capital in the land as extraordinarily productive. Business men, and many mod- ern economists, adopt the former mode of expression. A property that yields regularly the income of a capital of $100,000 is a capital of $100,000. It matters little what mode of expression we employ so long as we bear in mind the fact that the value of the land is merely the capitalization of its rent at the current rate of interest; that with an increase in the rent of a given tract of land, if interest on capital in reproducible goods remains unchanged, the capital value of the land automatically increases, until the ratio of the capital value of land to its net rent is the same as the ratio of the capital value of a group of typical reproducible capital goods to their net rent; that with a decline in the interest rate on capital in repro- ducible goods, the value of land yielding a given rent increases until the rate of interest on so-called capital in land is no higher than the rate of interest on other forms of capital. If the rate of interest on capital in reproducible RENT, INTEREST, AND CAPITALIZATION 23I capital goods falls, it is because the earning power of such goods declines. If the rate of interest on capital in land declines, it is usually because the land is revalued at a higher figure — that is, counts for a larger sum of capital. 14. Increase in the capital of society causes the value of land to rise for two reasons, (i) because it raises the rent of land, and (2) because it changes the rate at which a given rental is capitalized. We have already seen that with increase in the social fund of reproducible capital the productivity of such capi- tal declines ; the rate of interest falls, and a larger share of the product of society takes the form of ground rent. This of itself would have the effect of increasing the capi- tal value of land. The decline of the interest rate affects the value of land further through changing the rate at which a given rent is capitalized. If the current rate of interest is ten per cent, a certain field may produce a net rent of $1000. This sum, capitalized at ten per cent, gives a value of ;^ 10,000, which we may, if we choose, call the capital invested in the field. At the end of two decades the current rate of interest may have fallen to five per cent. This would naturally increase the rent of the field in question — perhaps to ^2000. This rent we must now capitalize, not at ten per cent, as formerly, but at the new current rate of five per cent. The value of the land thus comes to be ^40,000. 15. Summary. Rent, in the most general sense of the term, is the product of any concrete capital good. For practical reasons, however, a study of rent may best be limited to goods of a fairly permanent character. The gross return to a capital good may be divided into two parts, one of which serves to replace the good when it is worn out, while the other is a net income to the owner of the 232 INTRODUCTION TO ECONOMICS good. This net income, or net rent, may be regarded as the sum of interest on the capital embodied in the good. In practice, the rent of a durable capital good may con- veniently be treated as a residue remaining after the cost of labor and of perishable goods has been deducted from the aggregate product. Where several durable goods en- ter into a permanent combination, the rent of any one may be determined by comparison with other combinations into which this particular good does not enter. The rent of reproducible capital goods tends, in the long run, to equal interest, at the current rate, on the cost of duplicating such goods. The rent of goods that can- not be duplicated, such as land, can be arrived at only through a study of the forces determining wages, interest on reproducible capital, and other outlays in production. As wages and interest fall, or as value of product rises, the rent of such goods increases. The value of irrepro- ducible capital goods is arrived at through a capitalization of their rent at the current rate of interest. In a develop- ing country land values rise on account of increase in rent and on account of decline in the interest rate serv- ing as a basis of capitalization. CHAPTER XIV ENTERPRISE AND BUSINESS PROFITS 1. Exceptionally favorable opportunities for the employ- ment of labor and capital are to be found in every progress- ive society. In many parts of the United States a careful observer of business conditions will note neglected opportunities for the production of wealth. In one section of the country there is a great demand for thoroughbred stock ; very high prices are paid for such stock, yet men are slow to equip themselves for meeting the demand. Another section of the country is known to present excellent opportunity for the production of high grade fruit, yet it has few orchards, and these of indifferent quality. Fertile lands are to be found that yield scarcely anything for lack of water, yet plenty of water for irrigation is at hand in a near-by stream. Waterfalls offering abundance of cheap power remain for years unutilized. Nor are exceptional opportunities for wealth production limited to the exploitation of neglected natural sources of wealth. The richest opportunities are often those of or- ganizing in a more effective way businesses already exist- ing. In a dairying country, when each producer works in ignorance of what other producers are doing, he must learn through experience many facts concerning methods of production and marketing that could be learned much more cheaply through the experience of others. Moreover, the product of such a country lacks uniformity and its supply is very irregular, with the result that prices are unnecessa- rily low and fluctuate seriously. An organization of the producers may decidedly increase their income. 233 234 INTRODUCTION TO ECONOMICS In earlier chapters we have seen what advantages flow from the concentration and combinatioa of production. At a particular time there is one form of organization best adapted to the circumstances, and to introduce this form of organization offers an opportunity for rich reward to the man or men who are enterprising enough to undertake the task. In less conspicuous form, exceptional opportunities are continually presenting themselves. In a certain city there is a corner lot, now occupied by a tumble-down dwelling house, that would furnish an excellent location for a gro- cery or hardware business. A block of ground in the resi- dence part of the city, now occupied by a few old cottages, could, in view of present conditions, be profitably cleared and sold in large lots to persons intending to build expen- sive homes. It may be said, in general, that whenever a new business is undertaken, it is with the purpose of ex- ploiting a preexisting opportunity for exceptional returns. The same thing is true when an established business enters new fields of activity. 2. The function of combining labor and capital for the purpose of exploiting a business opportunity is known in economics as enterprise. In a growing town the time has become ripe for the establishment of a wholesale grocery business. Months and years may pass before any one undertakes to supply the need for such a business, but eventually a man of suffi- cient business prestige to command confidence proceeds to get together the requisite funds for launching the business. He may be wealthy enough to supply the necessary capi- tal himself; he may supply a part of it and borrow the rest; or he may associate with him in the enterprise other persons having capital. The organizing of the business involves labor on his part, and some of it of a very high order. The essential part of his activity is not, however, ENTERPRISE AND BUSINESS PROFITS 235 the labor involved. What difEerentiates him from a laborer working in a routine way is the fact that he sees a new opportunity clearly and takes the steps necessary to utilize it. And the reward which he anticipates consists, not in wages for his labor, but in the exceptional returns to all labor and capital employed, from which he expects a share for himself. The? man who performs the function of combining labor and capital for the exploitation of an opportunity is known in economics as the enterpriser, or entrepreneur. To illustrate the functions of the enterpriser, we will suppose that a man of known integrity and business capac- ity decides to establish a manufacturing business. He borrows at a stipulated rate of interest all the capital that the enterprise requires. The actual work of the business man himself, we will say, is a negligible minimum. His secretaries collect the information on which he acts in de- ciding to found such a business. His attorneys arrange the details of the loan contract; his banker finds for him the persons who have capital to lend. Even the business of selecting a building and choosing a responsible manager is given over to salaried employees. What, then, is the connection of the business man with the enterprise.' He lends it his name, he assumes legal responsibility for the conduct of the business, and he reserves to himself the ul- timate power of approving or vetoing proposals made by his staff. These are the only functions that the enter- priser must necessarily retain. In real life it would be difficult to find a man who is an enterpriser and nothing more. It is rarely the case that a man without capital can borrow any considerable amount of it. Lenders demand the security that only the owner of independent resources can give. It would, moreover, be a fortunate enterpriser who could find secretaries and managers who can be trusted to the extent we have as- 236 INTRODUCTION TO ECONOMICS sumed. A part of the labor of oversight must ordinarily be performed by the business man himself. The fact that the same man ordinarily combines in himself the functions of enterpriser, laborer, and capitalist does not, however, make the functions indistinguishable. 3. Opportunities for enterprise are most common where economic conditions are rapidly changing. When the population of a city increases rapidly, 'Oppor- tunities for new business enterprises emerge one after another. Profits are to be made by converting residential districts to business uses, and by opening up new residen- tial districts upon lands adjacent to the city. Increase in the number of large incomes in a city offers opportunity for businesses catering to the tastes of the rich. The in- creasing numbers of persons without means renders pos- sible the establishment of new manufacturing enterprises. A multitude of business opportunities arise when a new railway line is opened; when improvements are made in the means of producing or transmitting power; when the tastes of consumers undergo a marked change. Enter- prise languishes, on the other hand, where population is stationary and habits of consumption are fixed. Inventions of a far-reaching character may give a fillip to enterprise even in such a community; but after a time readjustments are made, and enterprise again becomes dormant. It is in new and developing countries like the United States where enterprise assumes its highest importance. 4. Enterprise often entails risks, but this is not necessarily the case. An enterprising person, struck by the natural beauties of a mountain valley, decides to erect a summer hotel. He sinks his own capital and whatever capital he can borrow in erecting a building and in improving the grounds about it. The outcome may greatly exceed his expectations; throngs of patrons may seek admission to the hotel, en- ENTERPRISE AND BUSINESS PROFITS 237 abling him to fix his charges at a very high level; and even this may increase the popularity of his house, since high charges are often accepted as a guaranty of exclusiveness — the quality for which men are most willing to pay liberally. The event may, however, be far less favorable ; a few strag- gling seekers for rest and quiet may be the only patrons secured, and these may hardly pay the running expenses of the business. In such a case the enterpriser loses not only his prospects of prosperity ; he also loses, for all practical purposes, whatever capital he has embarked in the enter- prise. Many enterprises, however, involve no risk. When a railway opens a new country, much of the land along the route is certain to rise in value, and those who are enterpris- ing enough to buy before the rise are certain of a substan- tial return. The success of many enterprises involving or- ganization is capable of almost mathematical demonstration. The exact measure of profit is usually uncertain, but that such an enterprise will afford the requisite minimum of return, may be clearly shown. The highest type of enter- priser is the one who places nothing at stake until his cal- culations prove that there is practically no chance of loss. 5. The existence of valuable opportunities involving no risk implies the fact that competition does not operate freely. The question naturally arises, how can opportunities in- volving no risk, or little risk, be found } If competition were keen, each opportunity would be seized upon as soon as the chances of gain seemed to outweigh the chances of loss. But competition seldom operates perfectly. Many men are conservative, and show a preference for the well- established routine. These men overlook most of the op- portunities within their reach. Other men see the oppor- tunities, but through lack of capital, business prestige, or managing ability, are not in a position to avail themselves of the opportunities that are presented. This is especially 238 INTRODUCTION TO ECONOMICS the case where the initial outlay required is a large one. You may know of an opportunity for the profitable invest- ment of $100,000; but if you have no capital of your own, you will find it almost impossible to induce other men even to listen to your project. The opportunity will probably wait for the man who has both enterprise and ;^ 100,000, or sufficient business prestige to induce other men to intrust him with their capital. 6. The income which originates in enterprise is known as profit. It may be defined as a surplus remaining after costs, including interest on all capital and wages for all labor, have been met. In earlier chapters it has been shown that the returns to the average business enterprise must be sufficient to cover all costs of production, including under this head not only actual outlays, such as prices paid for materials, wages of hired labor, and interest on borrowed capital, but also ordinary returns on the capital owned by the business man himself and a reasonable wage for his labor. An excep- tional opportunity is one that will do more than this. A surplus remains in the hands of the enterpriser after all costs have been met. This surplus is known in economics as "pure profit," or more simply, as "profit." We must be careful to distinguish profit in this sense of the term from the income known as profit in the language of business. In the latter sense profit often includes interest on the enterpriser's capital and wages for his labor. Profit in the economic sense of the term is not essential to the continued operation of an established enterprise. Profit in the busi- ness sense of the term is a necessary income, since no one would remain long in a business unless he obtained a re- turn representing interest on his capital and wages for his labor. 7. The profits from an enterprise are commonly due to the fact that labor and capital, in that enterprise, are unusually ENTERPRISE AND BUSINESS PROFITS 239 productive, but are rewarded according to the standards gen- erally prevailing. In any important industrial center the productivity of labor and of capital may at a given time vary from industry to industry, while the wages of labor and interest on loan- able capital vary little, if at all. We may arrange the different industries of such a center in a series, according to the degree of productivity of labor and capital in each one. Labor and capital will, as a rule, receive no higher rewards in any industry than in the one that stands lowest in the series. If we assume that in this least productive industry labor and capital receive all that they produce — and we cannot assume that they receive more than this — we see clearly that they must receive less than they pro- duce in all the industries higher in the series. In the more productive industries the products of labor and capital afford a surplus above wages and interest, which takes the form of a profit to the enterpriser. Let us suppose that the American public, awakening to the significance of the ghastly record of railway accidents, insists that steel passenger coaches replace the wooden cars now in use, and withholds its patronage from railway companies that refuse to change their equipment. The demand for steel cars would become enormous. The car- building companies, for a time, could sell their output at very high prices. The productivity of labor and capital in such establishments, measured in terms of price, would be abnormally high. But the wages of laborers engaged in building steel cars would be practically no higher than the wages of equally skilled laborers in any other branch of the iron and steel industries. There would accordingly be a surplus above costs, or a profit to the enterpriser. The car-building companies would pay no higher rate of interest on borrowed capital than any other manufacturing com- panies in the vicinity. A surplus originating in the ab- 240 INTRODUCTION TO ECONOMICS normally high productivity of capital would thus be added to the profit from labor. In any industry the productivity of labor and capital may vary from establishment to estabUshment, although there may be no variation in the rates of wages paid. We may, if we like, arrange the establishments in a series, ac- cording to the degree of productivity of labor and capital, just as we did in the case of industries of varying produc- tivity. No higher wages or interest will be paid by any establishment than by the establishment working at the greatest disadvantage. As this establishment will pay to labor and capital no more than these agents produce, it follows that the better establishments will not need to pay out in wages and interest the whole product of labor and capital. A profit is left over for the enterpriser. 8. Profits, in some instances, are explained by the fact that labor a7id capital, though not more than normally pro- ductive, are secured at abnormally low rates. Certain classes of laborers are in an exceptionally weak position, and may be compelled to accept wages decidedly lower than the prevailing rate. Immigrants from countries with a different language and a lower standard of life must often accept conditions of employment that are exceedingly unfavorable. In some cases, indeed, they have been held in ^z^^jZ-bondage and compelled to work at wages that are unreasonably low. Where employers are of one race and employees of another, a set of institu- tions may develop which give the employer whatever re- mains of the product of labor above a mere minimum of subsistence. In some parts of the United States convicts and persons condemned to the workhouse are farmed out at rates that enable the employer of such labor to reap large profits. Women employed under the sweating sys- tem, and, to a less extent, women' employed in factories and shops, are often paid less than their labor is really ENTERPRISE AND BUSINESS PROFITS 241 worth, according to competitive standards. In the history of every industrial country, instances have appeared of large profits founded upon the exploitation of child labor. A similar exploitation of capital sometimes occurs. Not many years ago, in some of our states, persons intrusted with public funds habitually employed such funds for their own advantage. Such a course of action, even when not unlawful, was generally disapproved, and hence was kept secret, so far as possible. Loans of such funds were made at rates low enough to pur- chase silence from the borrower, who, accordingly, was placed in a position where he could make large profits. Trustees having little interest in their wards have been known to lend the funds intrusted to them at abnormally low rates. Instances of this kind are by no means so rare as they are generally supposed to be ; but recognition of this fact must not lead us to the view that profits are normally the result of conscienceless exploitation. 9. Profits may arise from the transportation of labor or capital from regions of low productivity to regions of high productivity , under contracts in which rewards are based tipon standards prevailing in the regions of low prod- uctivity. Let us suppose that an employer of large numbers of unskilled laborers in the United States sends agents to Europe, or even to the Orient, to obtain a supply of labor. What the agent will offer for, say, two years' labor will be the local rate of wages for that period of time together with such a premium as may be necessary to overcome the reluctance of laborers to leave their native land. The cost of labor is thus determined chiefly by the standards of producti\aty prevailing in countries from which the laborers are imported, while the value of the labor to the enterpriser is determined by American conditions of prod- uctivity, which are admittedly more favorable. By virtue 242 INTRODUCTION TO ECONOMICS of the labor contract the employer is thus enabled to re- tain for himself a part of the product of the labor. It is obvious that the possibility of obtaining a profit of this nature depends in large measure upon the character of the laws relating to labor contracts. If the enterpriser cannot enforce the contract by law the laborers whom he has imported may desert him before their services have yielded adequate compensation for the cost of bringing them to the country. In the United States to-day, not only would such a contract be unenforceable, but the importation of laborers from foreign countries under such contracts is a punishable offense. This was not formerly the case, and one of the important sources of profits in early American eco- nomic history was of the character that has been described. There is reason to believe that the system is still exten- sively employed in the United States. The importer of contract labor relies upon the ignorance or loyalty of the laborer to protect him from loss through the repudia- tion of contracts. In many parts of the world, especially in the tropics, the contract labor system is widely used. There are companies which make it their sole business to supply enterprisers with contract laborers from China and India. Such companies derive their profit from the product of the laborers, part of which is made over to the company by the enterpriser who employs the laborers. We need not here consider the reasons that have led to the general condemnation of enterprise that rehes for its profits on contract labor. What we are more immediately concerned with is the possible extent of profits of this nature. Let us suppose that the Chinese coolie in his own .home can obtain an annual wage of $50, while his services on a Spanish-American plantation or other enterprise are worth ^250 per annum. Allowing ^150 for bringing the laborer from China and for his return, and ^50 a year to overcome his reluctance to leave his native land, there would remain. ENTERPRISE AND BUSINESS PROFITS 243 on a two-year labor contract, a profit of ^150 to the enter- priser, if he imports the labor directly, or to be divided be- tween the enterpriser and the coolie labor company, if the latter acts as intermediary. We may apply the same reasoning to the case of profits arising from the transfer of capital from regions where its productivity is low to regions where its productivity is relatively high. A mortgage; loan company may borrow capital in New York at five per cent interest and loan it in Texas at seven per cent. The loan company thus receives a profit of two per cent. How is this profit produced.' Clearly it is a part of the product of the capital set at work in Texas. 10. Profits may arise when commodities which sell at prices covering costs in high wage-standard regions are worked up in regions tiaving a low wage-standard. The prices charged by American bookbinders for the binding of books are based upon the cost of labor in this country, which exceeds the cost of equally efiSdent labor in foreign countries. There are men who ship books from the United States to Paris to have them bound, as the cost of transportation is not high enough to equal the saving in wages. The net saving represents a profit to the enter- priser. There are metroJDolitan publishing houses that have printing done in small towns, where rates of wages for printer's labor are less than in the large cities. The profits of Southern cotton manufacturers were for a long time de- pendent upon the fact that, while the prices they received for their products were held at a level sufficient to cover costs in New England, the wage level in the South was lower than that of New England. Great profits were gained by Japanese cotton manufacturers by virtue of the fact that while the prices of cotton goods in the Orient had to be sufficient to cover the high labor costs in America and England, efficient labor could be had in Japan at very low wages. 244 INTRODUCTION TO ECONOMICS Profits may also arise through transferring an industry from a region of dear coal to a region of cheap coal. If a commodity is expensive to transport, profits may be made by removing the industry producing it to a point near the centers of consumption ; if the materials entering into the production of a commodity are exceedingly bulky, profits may be made by removing the industry to points near the source of supply of materials. With changes in the tech- nique of transportation and in charges for carrying goods, there are changes in the relative advantages of different producing centers ; and those enterprisers who can adapt themselves quickly to these changes are able to gain profits. 11. Under certain business conditions, enterprisers as a class may reap profits, owing to the fact that the rates of wages and interest are slow to change. In times of business prosperity it often happens that the . prices of almost all commodities rise ; or, what amounts to the same thing, the products of labor and capital, measured in terms of price, increase. For a time enterprisers fear that the rise in prices is a merely temporary phenomenon, to be followed, perhaps, by a fall of prices to a level lower than that existing before the rise. So long as enterprisers maintain this attitude, they naturally refrain from enlarg- ing their businesses. No enterpriser attempts to entice away the workmen in the employ of other enterprisers, as he would do if he believed that the high level of prices would be maintained, nor does he increase his demands upon the fund of loanable capital. There is accordingly no reason why wages and interest should rise. The effect of the rise of prices is thus to increase the price of the products of . labor and capital without increasing the cost of labor or of the use of capital. If before the rise in prices labor and capital received the whole value of their products, it is ob- vious that they receive less than this after the rise. A part ENTERPRISE AND BUSINESS PROFITS 245 of the product of labor and of capital remains in the hands of the enterprisers as a profit. 12. Profits are, in most instances, a temporary form of income. The sources of profit that have been described have one characteristic in common : they cannot flow for a very long period of time. An importer of coolie labor may, for a time, make large profits ; but if he does so, other importers appear, and either force up the price of this kind of labor at its source or depress the value of the services of coolie labor in the importing country. Sweat-shop contractors may for a time make large profits out of underpaid labor ; but in the end the number of contractors increases, and this either raises the wages paid to this kind of labor, or, what is more commonly the case, reduces the prices that are paid to contractors. Profits depending upon local cheap- ness of labor eventually disappear on account of increase in competition for such labor and rise in its price, except in cases where the supply of such labor is practically un- limited, as in the Orient. In such cases the industry must eventually develop to such an extent as to create a large increase in the product, with a consequent reduction in its price; and thus, in the end, a level of prices of finished products is established which corresponds with the lower cost of labor, and leaves no margin for profits. If profits depend upon superiority of methods, these methods, in time, are universally adopted, and prices fall accordingly. If profits depend upon industrial misadjustments that leave some industries undersupplied with labor and capi- tal, they are eventually eliminated by migration of labor and capital from the fields that are oversupplied to those that are undersupplied. The general profits that attend business prosperity are wiped out by readjustments in the prices of products and in wages and interest. A particular enterpriser may, indeed, obtain a continuous 246 INTRODUCTION TO ECONOMICS income from profits. When he finds that one source of profit is running dry, he searches out another. This im- plies a rapidly developing state of industry, such as one finds in new countries like the United States. In this country it is not difficult to find instances of men who have enriched themselves now from one source of profit, now from another. 13. Profits dependent upon the various forms of monopoly may display a high degree of permanence. One of the most important sources of profit is the intro- duction of new and more fruitful methods of production. So long as such a method is confined to one out of a number of competing establishments, prices remain at a level which covers cost of production in the establishments which do not employ the new method. If the new method of pro- duction is really an innovation in industry, and if it is of such a nature as to admit of definite description — as, for example, a mechanical device for saving labor — the per- son who invented it may take out a patent, which will as- sure to him the exclusive right of using it for a period of time — seventeen years, in. the United States. During this period he may continue to enjoy the profits arising from the use of the method. He may, of course, sell the right of use to other persons, in which case he makes labor and capital more productive in the establishments buying the right, reserving for himself, in the shape of payments for the use of the patent, a part of the product of these agents of production. Somewhat analogous to the profits arising froni a patent are the profits arising from the use of a trade-mark or from the " good-will " of a concern. A certain brand of soap has, let us say, a reputation for purity, established by long years of honest business. Another soap bearing an- other name may be just as pure ; but the consumer has no adequate means of determining qualities, and therefore ENTERPRISE AND BUSINESS PROFITS 247 prefers the brand which he has always believed to be good. It is evident that the manufacturers enjoying such a firm hold on the popular favor can charge somewhat higher prices for goods of a given grade than can manufacturers who have their reputation yet to establish. So a merchant who has established a reputation for upright dealing, or who has succeeded in attracting to himself the patronage of the wealthier classes of a city, can charge somewhat more than can his less fortunate competitors. The public esteem which an enterpriser enjoys — the good-will of the business — is sometimes only an insignificant source of profits. Sometimes, however, it is an exceedingly impor- tant source. In many cases the good-will of a manufac- turing or mercantile establishment is worth more than its aggregate tangible assets. The profits arising from patented processes and from the good-will of an establishment fall under the general head of monopoly profits. The surplus returns to an ordi- nary monopoly may be described in the same way. Let us suppose that all the manufacturers of tin plate agree to re- duce output twenty per cent in order to force up prices. If the various producers can be held to their agreements, and if new producers can be kept from entering the field, there is no reason why every enterpriser in the business should not enjoy a permanent profit. In the chapter on monopoly price we saw how this can be done. What the monopolists do, from the point of view of distribution, is this : A group of allied enterprisers throw a fence, as it were, around a particular field of industry. They limit the amount of labor and capital admitted to the field, so that the productivity of these agents remains higher than in the unmonopolized fields. The wages and interest paid by the monopoly are no higher than wages and interest in the unmonopolized fields. Consequently, there remains in the hands of the monopolistic enterprisers a surplus or profit. 248 INTRODUCTION TO ECONOMICS 14. Monopoly profits may be capitalized in the same way as other permanent incomes from property. We saw in the last chapter how it is possible to arrive at the value of a capital good, such as a field, by capitalizing the income at the current rate of interest. Permanent profits may be reduced to a capital value in the same way. If the profit from a monopoly is ^100,000 a year, and if there is good reason for believing that it will continue to be the same from year to year, the monopoly itself is worth as much as a sum of capital that will yield ^100,000 interest per annum. If capital generally yields five per cent, the monopoly is worth $2,000,000. If the enterprisers having such a monopoly were to sell out their interests, they would demand that sum over and above full payment for all the buildings, machinery, and other tangible assets of their business. The same thing is true of the profits arising from the good-will of a business. These profits will be capitalized, and the buyer of the business will have to add the capital value of the profits to the value of the tangible capital goods. The value of a patent is found in a similar manner. The only difference is that the profits from this source cease upon the expiry of the patent. What the buyer pays for is the right to a certain estimated income for a definite number of years. If the annual income is esti- mated at $5000 a year, and the patent has ten years to run, the simplest way of arriving at the value of the patent is to find the present value of each year's income, and add these sums together. If the current rate of interest is four per cent, the present value of $5000 due in one year is ob- viously equal to a sum which, plus interest for a year, will amount to $5000. That sum is about $4807. $5000 to fall due two years hence is worth a present sum which to- gether with compound interest at four per cent will in two years amount to $5000 — $4625. By a similar process ENTERPRISE AND BUSINESS PROFITS 249 — known as discounting — the value of each year's income may be ascertained, and by addition, the present value of the patent is established. 15. Profits usually play an important part in promoting economic progress and in directing the distribution of the productive resources of society. •All profits, whether monopolistic or not, are, from the point of view of distribution, a part of the product of labor and capital which various circumstances enable the enter- priser to retain for himself. It may therefore appear, at first thought, that the existence of profits is evidence of in- justice in the distribution of wealth. Upon reflection, however, we see that this is not true. Profit in many cases plays an important part in stimulating econornic progress ; in many other cases the existence of profit serves as a means of distributing the agents of pro- duction in such a way as best subserves the interests of society. An income that must exist if society' is to be pro- gressive and if the best disposition is to be made of its pro- ductive resources can hardly be regarded as unjustifiable. It is the hope of profits that induces the enterpriser to devise improved methods of production, or to adopt im- provements devised by oth ers. In doing this the enterpriser increases the productivity of labor and capital, reserving for himself, as long as he can, the benefits of this increased productivity. But sooner or later the new method finds general application in the industry, and the enterprisers are forced to yield up the benefits arising from it to labor and capital, in the form of increased wages and interest, or to the consumer of commodities in the form of lower prices. In the latter case all laborers and capitalists gain by an in- crease in the purchasing power of their incomes. When profits arise from a general increase in the de- mand for a commodity, the ethical title of the enterpriser to the income is perhaps not quite so clear. But such an 250 INTRODUCTION TO ECONOMICS increase in demand shows that the amount of labor and capital devoted to the industry affected by the increased demand should be increased. Under the competitive sys- tem this result can be brought about only through the action of enterprisers. Now, if enterprisers received no profit from enlarging old works and establishing new ones, why should they trouble themselves with doing this .' If, on the other hand, they may for a time keep for themselves as a profit a part of the price of their products, they will naturally endeavor to enlarge their works as quickly as possible. When at last as much labor and capital is de- voted to the industry as is socially expedient, profits cease through rise in wages and interest or through fall in prices. Of the forms of profit that are classed as monopolistic, those arising from patented inventions and from good-will need no defense. The former is the reward for one of the most important services to society. The inventor can never get for his services, at any time, more than they are worth to society ; at the expiry of the patent the inven- tion becomes the common possession of all. The profits arising from good-will, in the literal sense of the term, are a reward for honorable business dealing, and can be re- tained only so long as the enterpriser is worthy of them. 16. The profits of an ordinary monopoly cannot be ethic- ally justified. The profits of an ordinary monopoly, so far as they are true monopoly profits, stand on an entirely different footing. The productivity of labor and capital in the field controlled by the monopoly is rendered abnormally high, not merely through superior organization and combination of these factors in production, but largely through the maintenance of an artificial scarcity of them, which is directly opposed to the interests of society. While the action of any one out of a number of competing enterprisers, each striving ; to increase his own profit, usually operates to increase the ENTERPRISE AND BUSINESS PROFITS 251 aggregate wealth produced by society, the action of a com- bination of enterprisers striving to secure a monopoly profit operates to reduce the aggregate wealth production of society. Through his anti-social conduct the monopolis- tic enterpriser receives a permanent profit, the fruits of other men's labor and capital. The enterpriser who carries on business under conditions of competition receives, as a re- ward for his important services to society, only a temporary profit. It appears, therefore, that the elimination of monopoly profit through legislative action, if possible, is eminently de- sirable. It is, however, to be borne in mind that this "can- not always be done without injustice. We have seen that monopoly profit, being permanent, may be capitalized. If a combination of manufacturing enterprises makes possible a monopoly profit of ^100,000, the selling value of the com- bined enterprise — or of the capital stock representing it — is increased by the capital value of an income of ;^ 100,000. Now, the original promoters of the monopoly do not con- tinue to own it forever. Some of the stock in it may pass to their heirs ; some of it may be sold to persons who do not know that a great part of its value is merely the capitaliza- tion of a wrongful monopoly profit. If, then, the profit of the monopoly is eliminated, the latter class of persons find themselves deprived of an income the right to which they purchased in good faith as an income from capital. 17. Summary. In a progressive society exceptional opportunities for the employment of labor and capital are continually pre- senting themselves. The act of seizing upon such oppor- tunities is known as enterprise ; the income arising from enterprise is pure profit. The existence of profitable op- portunities is evidence of the fact that competition does not operate freely. From the point of view of distribution profit is an income 252 INTRODUCTION TO ECONOMICS created by labor and capital, but retained by the enterpriser. When labor and capital are abnormally productive, but are paid at normal rates, a surplus remains for profit ; when labor and capital are normally productive, but are paid at abnormally low rates, a similar surplus appears. The im- portation of labor and capital from regions of low produc- tivity to regions of high productivity, with the maintenance, in the latter regions, of the standards of pay established in the former regions, is one source of profit ; the transfer of an industry from a region in which standards of pay are high to a region where such standards are low is another source of profit. As a rule, profit is a temporary form of income. Mo- nopoly, in its various forms, gives to profit a fair degree of permanence. Monopoly profit is therefore capitalized like any other form of permanent income. Since profit is an income produced by the labor and capi- tal of one set of men and enjoyed by another set of men, it appears to demand an ethical justification. Competitive profits may be defended on the ground that they serve as an incentive to improvement, and help to adjustthe supply of each commodity to the demand for it. Such forms of monopoly profit as the royalties of an inventor and the receipts from the good-will of a business are easily de- fended. The profits of an ordinary monopoly cannot be defended, ethically ; their continued existence depends upon the preservation of a misadjustment of demand and supply. CHAPTER XV MONEY 1. Money is anything that practically all men are ready to accept in exchange for their goods , with the expectation of employing it in the acquisition of other goods. In the foregoing chapters frequent use has been made of the concept price, which of course implies the concept money, since price is nothing but exchange value, expressed in terms of money. It has been tacitly assumed that money is in general use and that it's value remains constant, price fluctuations being due to changes in the conditions of pro- duction or consumption of other things. The latter assump- tion, as every one familiar with recent discussions of economic policy is aware, cannot pass unchallenged. The value of money, like the value of all other things, is subject to con- tinual fluctuations, and these fluctuations give rise to some of the most important problems of practical economics. We may profitably begin this part of our study by con- sidering what it is that the plain man regards as money. Anything that is accepted by practically every one in ex- change for his goods or services, with the sole intention of exchanging it ultimately for other goods or services, is popularly regarded as money. This view, which is also that of many of the ablest writers on money, we may safely adopt as our own. Under different conditions of economic development, different concrete things have served as money, — shells, beads and other ornaments, bits of metal coined or uncoined, and even such commodities as cattle and furs. With the evolution of trade, a corresponding evolution of money has taken place, and those forms of money which were fitted for use when trade was merely an incidental 253 254 INTRODUCTION TO ECONOMICS part of economic life have given way to forms of money adapted to a complex system of commerce. 2. The origin of money is to be sought in a gradual and unconscious evolution in which certain articles of direct use came to be more and more frequently accepted m exchange merely as a means of acquiring other articles of direct use. The origin of money antedates all historical records. Nevertheless, we know enough about the life of primitive man to construct a plausible view of the circumstances under which money must have come into existence. In the earlier stages of human evolution exchange, at least in the modern sense of the term, was unknown ; hence, of course, money could not have existed. When it first be- came customary to make exchanges, goods were doubtless bartered directly for goods, as is sometimes the case even to-day. Certain articles, however, were more frequently the objects of exchange than others, as, for example, strings of seashells, articles of copper, silver, and gold suitable for personal adornment. Such articles, unlike the common necessaries of existence, could not be produced by any one desiring them. Not being essential to life, they would naturally be sacrificed by their possessors in time of need. The desire for such articles, on the other hand, could not be easily satiated. We can easily see, therefore, why articles of this nature should have been among the earliest to be freely purchased and sold. We can also see why persons having ordinary commodities to dispose of should have been willing to accept such articles with at least a half-intention of exchanging them later for other commodities. Men desiring such articles, and will- ing to make sacrifices to obtain them, could easily be found. Just at what point articles of personal adornment, as, for example, silver bracelets, ceased to be ordinary com- modities and became money it would of course be impossi- MONEY 255 ble to say. Some men may have accepted them solely with a view to a further exchange. Some may have ac- cepted them primarily with a view to further exchange, yet with the alternative of personal use before them ; still others may have accepted them with no intention of ex- changing them for something else. To the first class of persons, the bracelets would have been money ; to the second, neither money nor ordinary commodities but some- thing half way between ; to the last class they would have been merely ordinary commodities. If the last two classes were relatively insignificant, the bracelets would properly have been called money. We do not hesitate to call nickels and dimes money, although certain of the aborigi- nal inhabitants of the United States perforate all they can obtain and hang them in strings from their ears. 3. The functions of money are (i) that of medium of ex- change ; (2) that of store of purchasing power ; (3) that of measure of value ; and (4) that of standard of deferred payments. When a farmer exchanges a load of wheat for money, and immediately exchanges the money for household sup- plies, the money so far as he is concerned serves merely as means for exchanging the wheat for household supplies. If the farmer does not immediately purchase the supplies, but keeps the money in his strong box against future needs, we may say that the money serves as a convenient means of keeping the purchasing power originally repre- sented by the wheat through a period of time, or as a store of purchasing power. If the local dealer is at once a grain buyer and a dealer in household supplies, no money may actually be used in effecting the exchange. The value of the grain is estimated in terms of money, as is also the value of the household supplies, and the one quan- tity of money value is set against the other. In this case money is used solely as a measure of value. If the farmer 256 INTRODUCTION TO ECONOMICS delivers his wheat, but "trusts" the dealer with its value, the future obligation of the dealer to the farmer is reduced to definiteness in terms of money. The farmer is credited, not with forty bushels of wheat, but, we will say, with ^^35. In this way money serves as a "standard of deferred payments." The primary function of money is that of medium of exchange, and from it are derived the other three functions. Money serves as a store of purchasing power because of its universal acceptability in exchange. It serves as a measure of value because men are constantly weighing the value of other things against that of money. And for the same reason it serves as a standard of deferred payments. If you promise to deliver to me one thousand bushels of wheat a year hence, I have no very definite idea as to the sum of value I am to receive. If you prom- ise to deliver to me i^iooo a year hence, I have a definite idea as to the sum. 4. Anything serving as money should present in a high degree the qualities of uniformity, stability of value, and adaptability to transactions of varying magnitude. In the early modern commercial centers traders were always seriously handicapped by the great variety of coins used as money. In every business transaction it was necessary to examine the money offered in payment almost as carefully as the quality of the articles offered for sale. In many cases gold and silver coins passed by weight; but even in such cases there was always some question as to the real value of the money, as the coins of different countries were of different degrees of fineness. It is difficult to appreciate the advantages presented by a monetary system like that of the United States of to-day, in which one dollar represents the same value as any other. Hardly less important than uniformity is stability of value. If money is to serve as a store of purchasing power, MONEY 257 its value must not be subject to rapid fluctuations. If it is to serve as a standard of deferred payments, stability of value is of extreme importance. Imagine the inconvenience of a standard fluctuating in value as widely as do most of the commodities of common use. A man borrowing money for a six-months period might find himself, at the end of the period, compelled to pay back twice as great a sum of value as he borrowed ; or he might escape with paying half as great a sum. With such a fluctuating standard all contracts involving future payments of money would be- come highly speculative. For an advanced commercial nation, adaptability of money forms to transactions of varying magnitude is of great importance. In the rural districts of China, where trade is chiefly local and the articles of trade of low value, coins of one kind, and these of very low value, meet practi- cally all needs. In a country like our own, with the greatest variety of business transactions to be performed through the medium of money, a wide variety of forms of money is required. For the smallest transactions it is necessary to have coins of a value which is low, relatively to bulk, as bronze cents, nickel five-cent pieces. For sUghtly larger transactions, coins of silver, which represent a greater value per unit of bulk, are more convenient. For transac- tions involving still greater values, gold coins are better adapted than silver ; for the largest cash payments, paper money, which may be of any denomination, is the most convenient of all. How important is this variety in forms of money will be understood by any one who happens to be engaged in business in a town where at times the supply of small coins is not sufficient to meet the needs of petty trade, or in a section where silver coins are employed to the exclusion of paper in all transactions involving ^10 or less. 5. Uniformity in the medium of exchange depends upon effective governmental regulation. 2S8 INTRODUCTION TO ECONOMICS From very early times it has been recognized that the coinage of money is a business of such great public im- portance that it cannot be left to unregulated private enterprise. The private coinage of gold and silver has indeed sometimes been tolerated. In the United States as late as i860 privately coined gold was to be found in cir- culation. But experience showed then, as it had often shown in earlier periods of the world's history, that private coinage results in serious evils. Coins that circulated as of equal value differed as much as ten per cent in their gold content. Those who were least able to judge the probable value of such privately issued coins were likely to be cheated in trade with those who were better able to judge the value of these coins. Because of such evils the issue of coins by private individuals has been prohibited by law. All coins are issued directly by government, and measures are taken by every well-regulated state- to insure uniformity of value of money thus issued. 6. The function of government in issuing money m.ay be (1) to stamp the weight and fineness of metal in a coin ; or (2) in a restricted sense, to determine the value of m.oney regardless of the value of the m.aterial composing it. The government may hold its mints open to private owners of precious metal, coining on their account all the metal they offer for coinage. Thus any holder of gold bullion can take it to the United States mints and have it made into coins. In such case it cannot be said that the government determines the value of the coins issued. If there is a large production of gold, there is likely to be an increase in the amount of gold taken to the mints for coinage, and, as we shall see later, a tendency toward a decline in the value of the coins. The government assures the recipient of a gold coin that it contains the requisite amount of pure gold ; practically it assures him of nothing more. MONEY 259 When a metal is freely coined on individual account, there can be no perceptible difference in value between a given amount of the metal in the form of coin and an equal amount in the form of bullion. In the United States an ounce of uncoined gold is worth just as much as an ounce of gold coined. If for any reason gold in the form of coins should become • more valuable than gold in the form of bulHon, more bullion would be taken to the mints, until the difference in value disappeared. If uncoined gold became more valuable than gold in coins, coins would be melted down, until again the difference disappeared. A government may accept for coinage on individual ac- count either gold or silver, or both metals. When gold alone is freely coined on individual account, the monetary system of a country is said to be based upon gold monomet- allism. When both gold and silver are freely accepted for coinage, the monetary system is based upon bimetallism. The bimetallic system was generally employed in modern times until the nineteenth century. Early in that century Great Britain adopted gold monometallism, and in the latter part of the century the same system was adopted by all other important commercial nations. When a monetary system is based upon gold freely coined by government on individual account, the needs of trade require the presence of money composed of other materials, such as silver, nickel, bronze, and sometimes paper. The value of such forms of money is said to be determined by government, since it bears no fixed relation to that of the material from which it is made, as is the case with the money made from a metal freely coined. As a fact, the government issuing such money usually adopts measures designed to maintain a fixed relation be- tween the value of such money and that of gold. The gov- ernment of the United States regulates its currency in such a way that a five-dollar bill, or five silver dollars, or 26o INTRODUCTION TO ECONOMICS five hundred bronze cents are always equal in value to a five-dollar gold piece. Gold coin, which serves as a stand- ard, may rise or fall in value ; all other forms of money rise or fall with it. All the non-standard forms of money are said to be maintained at a parity with the standard form. 7. The only practical way of maintaining all the forms of money at a parity is through provision for the exchange of any form, for the others at the option of the holder. If a government issues a limited amount of paper money and makes it legal tender, that is, receivable at its face value in payment of all debts, public and private, such money may circulate at par, with no further provision for regulating its value. If I am offered a piece of paper which I am certain will be equivalent to ^lo in gold in the payment of taxes, or in the payment of my debts to other persons, there is no reason why I should not accept it as readily as $iO in gold. If much of this kind of money is issued, however, every one may hesitate to accept it in lieu of gold. Dealers may refuse to accept it in exchange for their goods ; accordingly, it may depreciate in value in spite of the fact that it is re- ceivable at par in payment of public dues and existing debts. To make certain that non-standard forms of money shall not fall below their face value in gold, it is customary for governments to make provision for redeeming them in gold on demand. In the monetary system of the United States are to be found coins of gold, silver, nickel, and bronze, as well as paper money. Part of the paper money consists of gold and silver certificates ; a small part of it, of treasury notes, issued in payment for silver bullion; part of it of "greenbacks" — promissory notes of the government, a leg- acy of the Civil War. All these forms of money are main- tained at an absolute parity by the government. The gold MONEY 261 certificates cannot fall below the value of gold coin, because for every dollar of such certificates there is a dollar's worth of gold coin or bullion in the United States Treasury, payable to the certificate holder on demand. The silver certificates are likewise secured in value by treasury holdings of silver. It is a part of the settled policy of the United States to maintain the silver dollars at a parity with gold; and although no specific provision is made by law for the ex- change of silver dollars for gold at the treasury, the privi- lege of making such an exchange would doubtless be ac- corded the holder of silver dollars if the latter showed any tendency to depreciate. A reserve of $150,000,000 in gold is held by the treasury for the purpose of redeeming any greenbacks that may be presented for redemption. Any one who desires may exchange the lesser silver, nickel, and copper coins for gold by presenting them in suitable quan- tities at the treasury. i. If a government fails to maintain all its forms of money at a parity, those forms that become depreciated tend to drive those that are not depreciated from circulation. This principle is known as Gresham's law. Let us suppose that the government of the United States issues a large volume of paper money, and makes no adequate provision for exchanging gold for such paper at the option of the holder. The value of such money would be very likely to depreciate, in terms of gold. After depreciation, every person who has payments to make in which the form of money is not specified, naturally uses whatever paper money he has in his possession, and retains his gold. If he has nothing but gold in the first instance, he exchanges it for paper, since he can get more than i^ioo in paper for $100 in gold, and then- makes his payments in paper money. Thus gold ceases to pass freely from hand to hand; if it is used at all, it is as a commodity, valued in terms of paper 262 INTRODUCTION TO ECONOMICS money. Thus the paper money issued by the United States in the time of the Civil War expelled gold and silver from circulation. When gold and silver are both freely coined it is usually impracticable for a government to maintain the two forms of money at an absolute parity. At one time an ounce of gold may be worth sixteen ounces of silver ; if then silver and gold are coined at a ratio of sixteen to one, — that is, if a dollar in silver contains sixteen times as much pure metal as a dollar of gold, — the two forms of money may circulate at par. Changes in the relative production of the two metals, or changes in the demand for them, over which no government has complete control, may cause silver to rise or fall relatively to gold. Since the value of coined metal, when coinage is free, cannot differ perceptibly from the value of uncoined metal, a rise in the market value of silver, relatively to gold, will raise the value of silver dollars above that of gold dollars. In such case the gold displaces the silver from circulation. A fall in the market value of silver would result in a dis- placement of gold from the coinage. In the monetary history of the United States, silver was at one time overvalued, in terms of gold ; at another time it was undervalued. As a result there was at one time a tendency for gold to displace silver from the coinage ; at another time silver tended to displace gold. The impossi- bility of keeping freely coined gold and silver at an absolute parity was one of the principal causes for the general adoption by the chief commercial nations of the mono- metallic system. 9. The value of money is its purchasing power. Under present conditions all men accept money in exchange for their possessions solely with reference to its employment in the purchase of other things. We may, therefore, define the value of money as its power to com- mand other things in exchange, or briefly, its purchasing MONEY 263 power. Other commodities are valued by some men for what they will bring in exchange, by other men for the satis- faction to be derived from them directly or indirectly. The ultimate cause of the value which men who hold ordinary commodities for sale ascribe to such commodities is the value ascribed to them by those who will use them in the satis- faction of wants. There are practically no men who ascribe value to money as a means of direct satisfaction. In this respect, accordingly, the value of money is a unique phe- nomenon, requiring special explanation. 10. The value of money is measured by its power to command commodities in general. The value of money, then, is its purchasing power. How is this power to be measured .'' Evidently not by reference to any particular commodity. A dollar may buy one and one quarter bushels of wheat to-day and only one and one fifth bushels to-morrow. We should not say that the value of money has declined, but that the price of wheat has risen. For there are probably many other commodities in respect to which the purchasing power of money has increased. To form a true estimate of the value of money we must consider its power to command commodities in general. In order to measure changes in the value of money we may form a list of the principal commodities, showing how much of each a dollar will command at differ- ent dates. By the method of averages wp can then ascer- tain whether the general purchasing power of money has changed. This method has long been employed by econo- mists, and it has been shown that through long periods of time the value of money fluctuates widely. A dollar will not buy so much to-day as it would have bought ten years ago. Very likely a dollar will buy more ten years hence than it buys to-day. 11. Changes in the supply of money tend to bring about changes in the value of money. 264 INTRODUCTION TO ECONOMICS The factors which determine the value of money, and hence the general level of prices, are so numerous and com- plex that only a provisional account of them can be given in this work. It is quite generally agreed that, other things equal, the greater the volume of money there is in the world, the lower will be the value of any unit of it. It is, of course, true that there are in operation many influences affecting prices besides changes in the volume of money. Hence we cannot say that if the volume of money, twenty years hence, shall be twice as great as it is to-day, prices will be higher than they are to-day. Yet this fact does not make it the less important for us to gain a clear view of the effect of a change in the volume of money. Let us suppose that through the discovery of a new gold field the world's supply of that metal is perceptibly in- creased : ^100,000,000 worth of gold, let us say, is taken from the new mines every year. Some of the new gold may be used in the arts, but the greater part of it will find its way to the mints of the nations, and issue thence as coin. The only use which money subserves is that of purchas- ing other commodities. The fortunate owners of the new mines will therefore enter the market as purchasers, either of consumable commodities or of capital goods or rights to capital goods — stocks, bonds, etc. There is no reason why the production of goods, whether consumable goods or instruments of production, should at once increase upon the discovery of gold. We may think of the supply of such goods as substantially unchanged. Now, new pur- chasers, with ;^ 1 00,000,000 to spend, appear upon the mar- ket. It is quite evident that competition for commodities will increase, and hence prices will rise. Let us assume, for the moment, that the rise in price of the commodities purchased by the first owners of the new gold has no effect in stimulating the production of such MONEY 265 commodities. The enterprisers engaged in the production of these commodities, then, will enjoy abnormally large money incomes as a result of the high prices at which they sell their products. They will have more money to spend on other classes of commodities for their own use. As the production of these, we assume, has not yet been affected, they also must rise in price. And so the new gold will percolate from one economic stratum to another, every- where raising prices. Our assumption that the production of the commodities demanded by the original owners of the new gold remains unchanged is purely arbitrary. The rise in prices would prob- ably lead enterprisers to enlarge their mills, or to run them overtime, and this would require more laborers and more cap- ital. The total supply of labor and capital at the command of society has not, however, been affected by the increase in the volume of money. The only way, then, in which an enterpriser can secure additional labor and capital is by enticing these agents away from the employment of other enterprisers. And this, it is evident, must raise the rates of wages and interest in the district where the expansion of enterprise occurs. After the rise in wages, each laborer has more money to spend ; he will therefore increase his purchases of the commodities suitable for his use. The supply of these, however, has not yet increased ; their price is, therefore, forced to a higher level. Similarly, the increased money income of the capitalists raises the prices of commodities taken by the members of that class. Eventually not only the price of all finished products, but the price of all raw materials and other capital goods, and of all labor, will be affected. The new gold may be first used to purchase consumable goods, or it may be used to purchase stocks or bonds. In the latter case, the first effect is an increase in the price of 266 INTRODUCTION TO ECONOMICS these securities. But the sellers of the securities will use the money to buy other things. Eventually the effect must be felt in the market for commodities and labor. 12. The issue of paper money by a government affects prices in the same way that an increase in standard money affects them. Instead of assuming that the supply of money is in- creased through new gold discoveries, we may assume that such increase in the money supply is brought about through an issue of paper money by the government. Suppose that the United States Government, in order to finance projected irrigation works, issues ^100,000,000 in paper money. This money will find its way into circulation through the pur- chase, by the Government, of additional supplies and the payment of wages to new employees. The supply of steel, cement, and other commodities needed by the Government, however, is not increased at once by the issue of new money ; hence the price of these supplies must rise when the Gov- ernment enters the market as an unanticipated purchaser. Similarly, wages are forced up by the new demand for labor created in this way. Through attempted expansion of business and through increased liberality of expenditure, the enterprisers and laborers first affected by the increase in the money supply transmit its effects, in the form of in- creased prices, to men engaged in other industries. In the end general prices and general costs are on a higher level than they would otherwise have been. 13. The em-ployment of substitutes for m.oney in effecting exchanges operates as an increase in the supply of m-oney. Not all exchanges are effected through the medium of money. Barter exists even to-day, although this form of ex- change may be ignored, as of very sHght importance. Many exchanges — indeed, much the greater number, in a society like our own — are effected through the medium of various substitutes for money. Let us suppose that A, a MONEY 267 person of unquestioned financial standing, buys of B com- modities worth $iOO, and instead of paying cash, gives a promissory note, due in six months. B in turn may buy ;Ji 100 worth of goods from C, paying for them not with cash, but with A's note, properly indorsed. C may use the same note to effect a purchase. At any given time a vast number of such notes may be at work effecting ex- changes, although each one may be transferred only two or three times before its maturity. The effect of the use of such notes as a means of exchange is the same as that of an increase in the supply of money. A man who can use a note in this way is enabled to enter the market for the purchase of goods as he could not have done if sellers all insisted upon cash payment. The effective demand for commodities, therefore, is increased, just as it would be by an increase in money. We need not at this point carry further the analysis of the effects of the introduction of such substitutes for money, as these effects will receive full discussion in the next chapter. 14. Changes in the volume of business affect the value of money. The value of money, as we have seen, is affected by changes in the volume of money and in the use of substitutes for money. It is also affected by changes in the volume of business to be transacted through the use of money. Where most men produce for themselves the principal commodities which they need, exchanging only their surplus for luxuries, a very little money will meet the requirements of trade. Where, on the other hand, men produce almost ex- clusively for sale, a large volume of money or of substitutes for money is required. If we imagine that men suddenly change from the system of production for immediate con- sumption to the system of production for the market, with- out any change in the volume of money and of its substitutes, we can easily see that the price level must be lowered. 268 INTRODUCTION TO ECONOMICS Where one commodity under the earlier system was offered for sale to the possessors of money, one hundred may be offered under the later system. Some sellers of commodities would then find that at the scale of values originally exist- ing they would be unable to find purchasers with money to pay. They would accordingly reduce prices, and so attract to themselves a part of the money supply. This would leave other sellers without buyers, and these in turn would lower prices. Thus the price level would fall or, what amounts to the same thing, the value of money would rise, until all sellers could find buyers at the prevailing prices. The assumption that the system of production could change thus rapidly without a change in the volume of the media of exchange involves unrealities, as we know that exchange and the medium of exchange must evolve to- gether. Yet it points to a real fact : that exchange may expand more rapidly than the volume of the media of ex- change, necessitating a lower price level. 15. An increase in the supply of money tends to raise prices ; but there is no definite relation between the degree in which the money supply is increased and the degree in which prices rise. It must now be evident that changes in the volume of money are not alone sufficient to explain changes in the value of money, or price changes. The development of substitutes for money and changes in the volume and character of business transactions must also be taken into account. Therefore, although we may say that an increase in the volume of money will, other things equal, raise general prices, we cannot say in what degree any specific addition to the money supply will raise prices. A doubhng of the money supply of the world might conceivably double prices. In all probability, however, prices would be increased by less or by more than one hundred per cent. For the read- justments consequent upon such an extraordinary expansion MONEY 269 in the volume of money would probably result in vital changes in the volume and character of business, the nature of which it would be impossible to predict. The reader is cautioned against the view that an increase in the money supply, brought about in any way that is known to practical experience, can leave the industrial mechanism unchanged while changing the scale of prices. We may also say that, other things equal, all prices will be raised by any important increase in the volume of money. But we cannot say that all prices will rise in the same pro- portion. Indeed, this is something that a little reflection on business conditions shows to be impossible. The supply of some commodities is easily increased, while the supply of other commodities can be increased only after the lapse of a considerable time. If the new money is spent largely on commodities of the first class, the attendant rise in price is quickly counteracted, in some degree, by increase of produc- tion. If it is spent on commodities of the second class, there can for a time be no such counteracting influence. 16. Changes in the volume of money give rise to practical economic questions of the greatest iinportance. The fact that not all prices rise in the same degree, and the fact that some classes of business relations cannot be immediately adjusted to price changes, renders the question of increase or decrease in the volume of money of vital practical importance. Some social classes are affected favorably and other classes are affected adversely by such changes. When general prices are rising, the wages of labor also tend to rise. But it may take some time after prices have begun to rise before enterprisers decide to extend their business operations. The demand for labor, accordingly, does not for a time increase and wages remain unchanged. The laborer receives no higher wages per week or month ; the commodities he buys with his wages have risen in 2 70 INTRODUCTION TO ECONOMICS price. It follows that the command of the laborer over the necessaries and comforts of life is for the time dimin- ished. Eventually, to be sure, enterprisers will endeavor to enlarge their businesses, and wages will rise. But if the prices of commodities continue to rise, it may well be that for a long period of time the rise in money wages will not be an adequate offset for the increased expense of liv- ing. It is a well-known fact that during the Civil War the prices of commodities rose far more than the price of labor. For many services compensation is fixed by law or by custom. The salaries of public officials remain fixed through long periods of time, notwithstanding changes in the price level. The postal employee receiving ^2000 a year is seri- ously injured if prices of commodities rise, since years may elapse before the Government grants him an increase of salary. Physicians' fees, in most cases, are regulated by custom and can seldom be increased on account of an ad- vance in general prices. The business relations most seriously disturbed by price changes, however, are those of creditor and debtor. Let us suppose that a farmer has borrowed $10,000, agreeing to pay off the loan in ten years, together with annual inter- est at six per cent. After the contract has been made, general prices, we will assume, rise twenty per cent. The farmer does not have to pay more than $600 interest each year, although the purchasing power of that sum has de- clined twenty per cent. At the end of the ten years, he will not need to pay more than $10,000, although this sum, for the same reason, represents a lower value. The creditor has been injured through the change in the price level just as much as he would have been if the debt had been arbi- trarily scaled down to $8333, prices remaining unchanged. The farmer, on the other hand, has gained materially. He receives higher prices for what he has to sell, and so is MONEY 271 enabled to pay the annual interest and the principal when due with much less sacrifice than would otherwise have been necessary. Enterprisers as a class are benefited through a rise in general prices. What they have to sell commands a higher price ; their costs of production increase, but not propor- tionately. Mention has already been made of the fact that wages may not rise so rapidly as prices. Furthermore, most enterprisers have some charges to meet that remain unchanged from year to year. If they occupy buildings and land not owned by themselves, these are probably held under long time leases. Until it is necessary to re- new such leases, the rental cannot be adjusted to the change in the price level. Most enterprisers are heavily in debt, and the rise in the level of prices has the effect of reduc- ing the burden of such debts, as in the case of the farmer of our illustration. A period of rising prices, to the active business man, is, therefore, a period of prosperity, whether it is a period of prosperity to the people as a whole or not. We have only to reverse our argument to show that in a period of falling prices, or rising value of money, the wage earners as a class gain, because wages do not fall so rapidly as prices ; those receiving salaries fixed by law or custom gain yet more, because a readjustment of such incomes to the new scale of prices is long delayed ; creditors gain through increase in the purchasing power of the interest and principal due them. The enterprisers as a class find profits succeeded by losses, and complain bitterly of busi- ness depression. 17. A monetary standard of fluctuating value results in senoits hardships ; it is therefore natural that efforts should be made to render the standard more stable through govern- mental action. The value of money can neither rise nor fall without in- flicting unmerited hardship upon some members of society. 272 INTRODUCTION TO ECONOMICS Any change in the value of money, therefore, is an evil. The evils of a rise in the value of money are, however, more easily perceived than the evils resulting from a fall in the value of money. When money rises in value — or, what amounts to the same thing, prices fall — enterprisers incur losses, and restrict their operations, reducing their working force as far as possible. Many debtors find themselves un- able to sustain their burdens, and become bankrupt. The hardships of unemployment and bankruptcy quickly attract public attention. The hardships arising from a fall in the value of money, or rising prices, are more widely diffused and less patent to the eye of the observer. Wage earners and the recipients of fixed incomes, whether from labor or from loaned capital, encounter greater and greater difficulty in making ends meet, but this fact receives little attention at a time when enterprisers great and small are enjoying pros- perity. Accordingly, it is quite natural that when prices are falling men should endeavor to mend matters through the action of government, while the evil effects of a general rise in prices are usually left to mend themselves. 18. In order to check the fall of prices which occurred in the period from 1874 to 1897, it was urged by many that silver should be restored to free coinage, so as to increase the money supply of the world. In the period from 1874 to 1897 the prices of com- modities steadily declined. In 1897 a dollar would pur- chase approximately the same amount of commodities that ^1.50 would have purchased in 1874. Many classes of producers were seriously injured by this decline in prices; business depression appeared at times to threaten wide- spread ruin. The debtor classes in all modern countries were seriously burdened, and in some parts of the United States, especially in the newer agricultural states of the West, a popular demand arose for an increase in the supply of money through the restoration of silver to free MONEY 273 coinage at the ratio of 16 to i — the ratio prevailing in the United States prior to 1873. It is not possible, in this book, to enter into the argu- ments that were urged for and against the free coinage of silver. We may consider, however, the probable effects of such a policy upon the American monetary system. 19. The adoption of free silver in 1896 would probably have expelled gold from circulation in the United States. It would have reduced the market value of gold and would have raised the market value of silver. In 1896 the market value of silver had fallen so low that an ounce of silver was worth less than one thirtieth of the value of an ounce of gold. Consequently, if silver had been admitted to free coinage, it would have been very profitable to buy up uncoined silver, both in America and in other countries, present it at the mints, and exchange the coined silver for gold, so long as any gold coins remained in circulation. It would obviously have been only a very short time before gold would have disappeared entirely from circulation. The great demand upon the silver supply that would thus have been occasioned would no doubt have increased the value of that metal. The gold displaced from the Ameri- can coinage would have been thrown upon the markets of other countries, and would have reduced the value of gold there. Nevertheless, an ounce of gold would proba- bly have continued to command more than sixteen ounces of silver — perhaps twenty ounces. A dollar (silver) would then have been worth less, in gold, than a dollar (gold) was worth before the opening of the mints to silver. It would have been worth still less relatively to commodities. That is, general prices in the United States would have been forced to a higher level. 20. An international agreement for the universal adoption of bimetallism might have prevented freely coined silver from 274 INTRODUCTION TO ECONOMICS Many persons who shrank from a policy which would probably have substituted a silver standard for the gold standard in the United States, nevertheless favored the adoption of free coinage of silver if the other commercial nations could be induced to follow the same plan. If all the countries of the world had agreed to coin sil- ver and gold freely at the same ratio, it is quite probable that coins of both metals would have continued to circulate side by side. The chief reason why gold would leave the cir- culation of a single country, if placed at an unfavorable ratio with freely coined silver, is that in other countries it is given a higher coinage value. More gold would be used in the arts, perhaps, but much of it would remain in the coinage if all countries gave it the same coinage value, relatively to silver. 21. Rise in prices in the decade 1 897-1906 checked agita- tion for the free coinage of silver. The adoption by the chief nations of free coinage of silver would no doubt have resulted in a higher level of prices. Other forces affecting prices had, however, begun to operate while the free-silver movement was still gaining strength. The production of gold was steadily increas- ing; in the decade 1890 to 1900 the amount of gold pro- duced exceeded that of any earlier decade in the history of the world. The annual production in the years 1901-1908 was still greater, and the increase in the supply reduced the value of gold, or, what amounts to the same thing, raised the prices of commodities. When it became evident that the rise in prices was likely to continue, agitation for the adoption of the policy of free coinage of silver practically ceased. 22. A government may raise or lower the value of money by increasing or reducing the amount of paper money in cir- culation. The evils of falling prices are so readily perceived by MONEY 275 almost every one, that in times of falling prices plans are usually put forward for releasing the price level from the uncertainties attendant upon the production of gold and silver by supplementing metallic money with paper money issued by government. Advocates of such plans usually propose that whenever general prices are found to be falling, the government shall issue additional paper money. When prices are rising, paper money received at the public treasury, it is proposed, shall be destroyed, until a reduc- tion in the money supply checks the rise in prices. In practice, paper money, when issued, usually takes the form of notes, issued in behalf of the government and alleged to be payable at the treasury on demand. But a government of a sovereign state cannot be compelled to meet its promises unless it chooses to do so. Hence the person who receives such a note must take it with the in- tention of parting with it in the purchase of goods or in the payment of debts, not of presenting it at the treasury for specie. These notes therefore represent a net addition to the money supply. In order to give such notes currency, the government endows them with the legal tender quality. If the volume of paper money is narrowly limited, it may circulate at par. If occasionally we receive paper money in exchange, we know that we can use it for the payment of taxes or debts. So certain of this may we be, under the conditions, and so confident that others are in a Hke position, that we do not hesitate to accept paper money at par in exchange for our goods and services. If, however, an enormous amount of paper money is issued by the government, so that we are all likely to re- ceive more of it in exchange than we can certainly use at par, we begin to look upon it with suspicion. We exchange it, if we can, for "hard money" — gold or silver; if pos- sible, we stipulate that we shall be paid in hard money for 276 INTRODUCTION TO ECONOMICS our commodities or services, offering our goods, if neces- sary, at lower prices than we would accept if paid in paper. Relatively to gold, paper depreciates. If there is very much of it issued, no one pays gold if he can avoid it, but uses paper instead. Thus specie disappears from circula- tion, and paper becomes the only money in use. Under the circumstances it is the worst possible kind of money : it fluctuates widely in value, falling with rumors of addi- tional issues, rising when it is rumored that the govern- ment intends to redeem it. At every change in its value some men gain unmerited profits and others suffer un- merited losses. If, as has been said, a government exercises great mod- eration in the issue of paper money, depreciation may not occur. The increase in money will tend to raise prices, but not in very great degree, and if prices are tending down- ward this effect may be beneficial. Why, then, do practi- cally all students of monetary science agree that paper money is always an unmitigated evil .■" Because govern- ments almost never exercise moderation in the issue of paper money. They resort to paper money in time of need, usually while carrying on war. Thus they obtain funds without burdening the people with taxation. As the expenses of the war increase, more and more paper money is issued, until hard money is driven out of circula- tion, and the redundant paper currency falls lower and lower in value, as evidenced by constantly rising prices. Another objection to attempts on the part of govern- ment to regulate prices through the use of paper money is that while it is practicable, politically, to increase the circulation when prices are falling, it is not practicable to reduce the circulation when prices are rising. In order to retire paper money from the circulation, it is necessary to resort to additional taxation which will, directly or in- directly, bring the money to be retired into the treasury. To MONEY 277 increase taxation for this purpose would be a very unpopu- lar policy, especially since a majority of the population is likely to look upon rising prices as a sign of prosperity, and therefore an unmixed good. The plan of keeping prices at a fixed level by the use of paper money must therefore be dismissed as impracticable. 23. A currency based upon gold or silver freely coined displays a tendency toward reasonable stability of value un- der modern conditions. So long as the production of the precious metals was dependent upon the activity of men of small capital, work- ing on their own account, only the richest fields could be worked, and these only for a limited period of time. The supply of precious metals depended, therefore, upon the chance discovery of new fields, and was consequently very irregular. At present the principal supply of the precious metals comes from the reduction, by large scale enter- prise, of low grade ores, which are found in large masses in many parts of the world. If the supply of gold in- creases so rapidly that the value of gold money falls, or, what amounts to the same thing, general prices rise, the production of gold is discouraged through the rise in price of labor .and the materials and appliances used in gold production. If the supply of gold does not keep pace with the demand for it, and general prices fall, the production of gold is encouraged by the decline in wages and in the prices of goods used in the production of gold. We see, then, that there are forces at work which restrict fluctuations in the value of money. We must not, how- ever, exaggerate the potency of these forces. Within limits which are not so narrow as would be socially desir- able, the value of freely coined money fluctuates from year to year and from decade to decade. 24. Summary. Whatever men regularly accept in payment for their 278 INTRODUCTION TO ECONOMICS services or in exchange for their goods, with the sole pur- pose of exchanging it for other services or goods, is money. The primary function of money is that of a me- dium of exchange ; money serves also as a means of stor- ing value, as a standard of value, and as a standard of de- ferred payments. In order that money may be uniform in value, its issue must be regulated by government. As a rule, a standard form of money is established, and the government merely certifies the weight and fineness of metal contained in this form of money. Other forms of money are issued in limited quantities, and it is the aim of a well-regulated government to maintain these forms at a parity with the standard form. If there is more than one standard form, maintenance of parity between them is difficult, if not im- possible. When a government fails to maintain its various forms of money at a parity, the less valuable forms tend to displace the more valuable forms from the circulation. The value of money is measured by its purchasing power. The purchasing power of money is continually fluctuating, owing to changes in the supply of and the demand for money. Changes in the supply of money may be due to changes in the output of the metal from which standard money is made, or to changes in the volume of non-standard forms issued by government. Changes in the demand for money may be due to changes in the general character of business, or to increase or de- crease in the volume of substitutes for money. A rise in the value of money is tantamount to a fall in prices ; a fall in the value of money, to a rise in prices. General changes in the price level inflict serious injury upon some classes and give unmerited gains to other classes. Hence a popular demand for governmental regulation of the price level through expansion or contrac- tion of the money supply. The free silver movement of MONEY 279 recent years is explainable upon this principle. The adop- tion of free silver by the United States would probably have raised the world level of gold prices ; it would have placed prices in the United States upon a silver basis. Under ideal conditions, general changes in the price level might be prevented through the issue or retirement of pa- per money. Under existing conditions, since the pressure for higher prices is always stronger than the pressure for lower ones, a consistent policy of issue of paper money is impracticable. The only practicable corrective of rising prices is the automatic reduction in the output of gold re- sulting from the increased cost of extracting gold from the ore, just as the only practicable corrective of falHng prices is the automatic increase in the gold supply resulting from lower cost of gold extraction. CHAPTER XVI FINANCIAL INSTITUTIONS: THE BANK 1. An important function of the -modern economic organi- zation is the placing of the control of capital in the hands of those who can use it to the greatest advantage. In a complex industrial society it is natural that there should be some men possessing capital who are unable or unwilhng to employ it in business undertakings under their own management. Some men, while able to use part of their capital in the conduct of businesses under their own control, are unable to use all of it advantageously. And some men, while able to use all their capital part of the time, fail to find use for it during some weeks or months of the year. On the other hand, there are those who have not enough capital of their own for the proper exploitation of the opportunities for its employment which they com- mand, and still others, while having capital enough during the greater part of the year, require an additional amount during certain seasons. Accordingly, one of the functions of the modern indus- trial organization is the transfer of the control of capital from those who have a superfluity of it to those who can use it profitably. This function, which in view of the enor- mous amount of capital to be thus transferred is one of vast importance, may be designated by the term "finance." Institutions designed primarily to effect the transfer, or " placing," of capital are known as financial institutions. It is to be noted that we are here using the word "finance" in a sense in some respects more restricted, in some respects broader, than is usually conveyed by the term. But we are justified in this by the analogies of such words 280 FINANCIAL INSTITUTIONS: THE BANK 281 as " capital," " rent," "labor," etc., which have one mean- ing in economics and a slightly different meaning in popu- lar language. 2. The transfer of the control of capital may take the form of a loan or of a partnership agreement. Let us suppose that a mine operator holds a lease of ad- vantageously situated coal lands. To develop these lands he needs, we will say, a capital of ;^ 100,000. A retired merchant in the vicinity has ;^ 100,000 from which he de- sires to get an income without the labor of managing a busi- ness on his own account. The mine operator may borrow the ;^ 1 00,000, agreeing to pay a stipulated rate of interest. On the other hand, he may be willing to form a partnership with the owner of the capital, agreeing to share the profits in fixed proportions. In either case the capital is virtually placed under the control of the mine operator. From a legal point of view the distinction between the two methods of transfer of capital is clear. If the transfer is effected through a loan, the mine operator becomes the legal owner of the goods in which the capital is invested, subject to the claims of the lender for interest and principal. The lender has no voice in the management of the business. If the transfer of capital is effected through a partnership agree- ment, the capitalist becomes part owner of all the capital goods employed in the business, and is entitled to a voice in the management of it. From an economic point of view, the chief distinction is that in the case of a loan transfer of capital, the capitalist receives a fixed income, not affected by the vicissitudes of the business, while in the case of the partnership transfer, the capitalist receives a share of the proceeds of the business, fluctuating with the alternation of prosperity and depression. 3. A productive loan is the transfer of capital, reduced to terms of money value, usually under a definite agreement as to charges for its use and as to time of repayment. 282 INTRODUCTION TO ECONOMICS In its simplest form a loan is a transfer of a sum of money from one person to another, with the stipulation that a certain return shall be paid for its use and that at some future time, usually specified, an equivalent sum of money shall be repaid. The borrower naturally transforms the money thus obtained into goods at the earliest possible moment. If the goods purchased are designed for sale or for use in further production, the loan is virtually the transfer of capital. Such a loan is called a productive loan. If the money is spent for commodities for consumption, the loan is called a consumer's loan. The productive loan is by far the more common, and we shall concern ourselves chiefly with it. 4. A loan may be disguised under the form of a sale. Very frequently loans are disguised under the form of sales " on credit." The seller, instead of demanding spot cash for his wares, may agree to wait for a certain period of time — say, three months — before demanding payment. In this case the seller really lends the buyer a sum equal to the price of the goods. A company engaged in the manu- facture of agricultural implements sells a self-binder to a farmer. The latter has not the ready cash to pay for it, but expects to have the necessary sum four months later, when he sells his crops. He may borrow the money from a neighbor, giving his note, payable in four months, with interest. Or, instead of borrowing the money and paying cash for the machine, the farmer may buy it " on time," agreeing to pay for it at the end of four months. In this case we sometimes say that the farmer has purchased the machine with his credit. If we analyze the transaction into its elements, we shall see that this expression is inaccurate. The company has not merely sold the machine; it has also, in effect, loaned the farmer the money with which to pay for it. Every sale "on time" or "on credit" is a double transac- tion, involving a sale, in the proper sense of the word, and a loan of the capital represented by the goods sold. FINANCIAL INSTITUTIONS: THE BANK 283 5. Lenders intrust the, control of their capital only to those who have "credit" ; that is, reputation for honesty and ability to meet their financial obligations. It is, of course, obvious that loans, whether productive or consumer's, will be made only to persons who have "credit" ; that is, to persons who are regarded as sufficiently honorable and efficient to be willing and able to repay the sums loaned when they fall due. A man's credit may rest upon his reputation for' personal integrity and business ca- pacity; more commonly it rests, in part at least, upon the fact that he has property which, under the law, can be seized by his creditors in case of default in payment of his debts. There are some writers on economics who regard credit as a mysterious productive instrument, a form of capital, or at any rate a substitute for capital. The illustration given in section 4 shows that this view has no justification. What the farmer cuts his wheat with is a capital good, embodying capital furnished either by his neighbor or by the agricul- tural implement company. This capital existed before the farmer gained possession of it, and would doubtless have been employed productively by other persons if the farmer had not decided to buy a machine. The fact that he buys the machine with borrowed capital shows that he believes that he can make this capital yield more than the interest which he must pay for its use. His " credit " enables him to pro- cure capital to use in an employment which he believes to be superior to the average in productivity. If he is right in his opinion, he is able to keep for himself a part of the product of this capital, as a profit. But the profit is not produced by his credit, any more than the wheat is cut by it. 6. A document in which the claim of the lender upon the borrower is reduced to written form, is known as a credit in- strument. If the claim thus reduced to writing can be sold 284 INTRODUCTION TO ECONOMICS and purchased, it is known as a negotiable credit instru- ment. The contract between the lender and the borrower is sometimes merely verbal, and rests for its fulfillment upon the honor of the borrower. In a larger number of cases, the lender enters the sums due him upon his books, and claims thus entered are usually collectible through the courts. This is the common form of loans effected under the guise of credit sales. The creditor may draw up a form instructing the debtor to pay the sum due at a speci- fied time. Such an instrument is known as a " draft " or "bill of exchange." The borrower may, at the time of raising the loan, sign a form which specifies the terms of the contract. Such an instrument is known as a "promis- sory note." The borrower may specify, along with the general terms of the contract, certain property belonging to him upon which the creditor will have a special claim in case of default in payment. A note thus accompanied by the pledge of property is commonly known as a "mortgage." The claim of a creditor upon his debtor is regarded in law as a form of property, and may ordinarily be purchased and sold like any other form of property. Claims repre- sented by promissory notes, due bills, and bills of exchange are very frequently purchased and sold, or " negotiated." They are therefore called " negotiable credit instruments," or simply, " negotiable paper." Transfer of such instru- ments is commonly effected by indorsement ; that is, the original claimant signs an order upon the back of the instrument, instructing the debtor to pay the sum due to a third party named in the order. 7. Under modern conditions there is a demand for and a supply of loanable capital for short periods of indefinite dura- tion, for short terms and for long terms. Corresponding with these conditions are call or demand loans, short term loans and long term loans. FINANCIAL INSTITUTIONS: THE BANK 285 Capital loans display wide variation in the length of time for which the lender surrenders control of his capital. Sometimes the lender retains the right of calling for his capital at any time he desires. Such a loan is known as a " call " or " demand " loan. Sometimes the date when the debt falls due is fixed at thirty, sixty, or ninety days. Such a loan is known as a short term loan. Sometimes the loan runs for five, ten, or fifty years. In this case the loan may be called a long term loan. This variation in the life period of loans is a reflection of the economic situation of the various classes of lenders and borrowers. At any given time there are men who have more capital than they need immediately ; they cannot tell, however, how soon they may need all they have. On the other hand, there are men who can use capital profitably for an in- definite period of time, who can yet return it to its owner whenever it is demanded. Thus a man who deals in stocks and bonds may find exceedingly profitable employment for capital in the purchase of such securities when prices are rising. If he is operating with borrowed capital, he can sell the securities at any time when payment is demanded, and so restore the capital to its owner. Again, there are men who can safely part with the con- trol of their capital for a definite period of time — say, from one to six months. Corresponding with this class of lenders is a class of borrowers who cannot agree to pay off a loan on demand, but who are able to make arrangements for payment at a definite date some weeks or months after borrowing the capital. The merchant will serve as a type of this class. He can safely purchase a stock of goods with the proceeds of a three months' loan, feeling quite sure that within the three months he will be able to sell the goods and so gain possession of the means of repayment. Finally, there is a class of lenders who have no desire for the early repayment of their capital. With satisfactory 286 INTRODUCTION TO ECONOMICS arrangement made as to the rate of interest to be paid, they may be willing to transfer control of their capital for a period of ten, twenty, or fifty years. There is a corresponding class of borrowers, who desire capital for investment in land, buildings, and permanent equipment, and who would be greatly embarrassed by the necessity of early payment. There are, then, three distinguishable sources of supply of loanable capital, and three corresponding sources of de- mand for it. In practical hfe, of course, with highly de- veloped financial institutions, there is a certain degree of interchangeability in the different funds of capital. Let us suppose that lenders of the first class place their capital in a bank, reserving the right of withdrawing it at any time. Experience shows that while some lenders withdraw their capital each day, new lenders will each day offer capital at the bank. Thus the bank has a permanent fund of capital which it may lend to business men for stated periods of time. Men who wish to lend their capital for long periods of time may place it with a bank, which may use it in short term loans, experience showing that when one business man repays a loan of this kind another will be ready to borrow the capital. 8. The principal functions of the bank are the collection of funds of loanable capital that are available for short periods 07tly, and the employment of such funds in call and short term loans. The bank proper is chiefly engaged in providing business men with demand and short term loans. The capital em- ployed in this way is in part the bank's own, and is perma- nently devoted to the purpose. By far the greater part of the capital, however, is supphed by other persons, who loan their surplus funds to the bank, receiving for its use either interest or some other form of compensation. Provi- sion for long term loans is usually made by various other financial institutions, such as the savings bank, the insur- FINANCIAL INSTITUTIONS: THE BANK 287 ance company, the investment company, and the exchanges. These institutions will receive attention in the next chapter. Our present concern is the economic nature of the transac- tions in which the bank proper is engaged. Let us suppose that a bank is established in a town which up to the present has had no similar institution. As the bank has doubtless better means for keeping money safe than are to be found elsewhere in the town, we may suppose that many persons will be glad to deposit with it any money which they do not immediately need, reserving the privi- lege of withdrawing it whenever they need it. On pay days salaried employees will deposit most of their month's earnings, expecting to withdraw the money day by day to meet their current expenses. Similarly, capitalists will deposit their annual or semi-annual interest receipts, to be withdrawn in like manner for current expenditures. Mer- chants will deposit surplus cash which they will not need to reinvest in stock for some days or weeks. Lenders whose loans have been repaid will deposit the money until they find another satisfactory opportunity for lending. Thus a great part of the community will use the bank in greater or less degree for the storing of surplus funds. The sums so deposited are credited to the depositors on the books of the bank. The use of checks, -or written orders for the transfer of funds, greatly increases the usefulness of the bank as a re- pository of funds of this kind. The depositor, instead of going in person to the bank to withdraw money for a pur- chase, may give a check for the sum involved in the trans- action. The recipient of the check may present it at the bank for payment, carrying away the sum in money. If he is in the habit of depositing his own surplus funds in the bank, he is more likely to deposit the check, instead of cashing it. The sum called for in the check is then trans- ferred, on the books of the bank, from the account of the one 288 INTRODUCTION TO ECONOMICS person to the account of the other. Thus payment is effected without the handling of money by any one. When the check system is well developed funds deposited with the bank may change owners scores of times without ever leaving the vaults. The cash intrusted to the bank may amount to a very considerable sum. At one time such deposits may aggre- gate i^so.ooo, at another time ^75,000. Experience may show that the volume of deposits never falls below $40,000. This sum of $40,000 may be regarded as a perpetual fund intrusted to the bank by the body of depositors, although actual ownership of each part of it is continually changing. The bank is, of course, under no obligation to keep in its vaults the money that has thus been intrusted to it. All that the bank is required to do is to hold itself in readiness to pay the money on demand. So long as it does this, it may use the deposits in any way that it may find profitable — observing, of course, such restrictions in the use of its funds as the law prescribes. And this fact indicates the economic nature of such deposits. They are loans, payable on demand, the depositor being the creditor, the bank the debtor. Up to the present point we have been concerned with the bank as a borrower of capital. We have now to con- sider its position as a lender of capital. Let us suppose that one of the inhabitants of the town is a manufacturer of hardware, who sells his products "on time " to jobbers. This manufacturer has sold, let us say, $i 0,000 worth of products, receiving in lieu of payment notes for $10,000 at three months' time. This means, as we have already seen, that the manufacturer has made a disguised loan of capi- tal to the jobbers. The manufacturer, however, needs his capital in order to continue his business of manufacture. He may, if his credit is good, borrow $10,000 from the bank, agreeing to repay the loan in three months. When FINANCIAL INSTITUTIONS: THE BANK 289 his debt falls due, the notes of the jobbers will also fall due ; accordingly, he will find himself in an excellent posi- tion to cancel his debt. Other business men will borrow from the bank under similar conditions as large a portion of the capital deposited with the bank as can safely be loaned. When one set of borrowers repays the sums bor- rowed from the bank, another set can easily be found. Thus the bank has a permanent volume of loans, as well as a permanent volume of deposits, although the borrowers, like the depositors, are continually dropping out and being replaced by others. 9. A bank loan may be regarded as the purchase of a credit instrument, such as a promissory note or bill of ex- In the foregoing section it was assumed that men who wish to secure capital from a bank borrow it directly ; and this, indeed, is often the case. When a business man bor- rows for the purpose of recovering the control of capital which he has loaned, under the form of a sale to other persons, he is more likely to take the notes received from the latter to the bank for sale. If the notes bear no inter- est, the bank, in purchasing them, will deduct from their face value interest for the time that will elapse before the notes "mature," or fall due. This process of deducting interest in advance is known as " discounting." In the language of the banking business, the purchase of a note is commonly spoken of as the discounting of a note, and notes purchased are called "discounts." Discounts are evidently nothing but loans. When a person desires to borrow capital from a bank, he offers his own note, which the bank usually discounts in the manner described above. We may think of the borrower as offering his own note to the bank for sale. Thus the whole volume of bank loans may be regarded as invest- ments in credit instruments. 290 INTRODUCTION TO ECONOMICS 10. A bank must invest funds intrusted to it in such a way that it can quickly regain possession of such funds if necessary. While the volume of funds intrusted to a bank may, under ordinary circumstances, remain fairly constant, ow- ing to the fact that new deposits offset withdrawals, it would be unwise for the managers of a bank to invest such deposits in ways that would make early payment of de- positors impossible. At any time depositors may lose confidence in the stability of a bank and demand the sums due them. Let us suppose that such a panic of the de- positors or " run on the bank " occurs, and that the bank has invested the funds intrusted to it in suburban real estate. Such property may not be salable, and all the bank can do is close its doors until such time as it can dispose of its real estate holdings and pay off its deposi- tors. This would, of course, mean the ruin of the bank, even though the real estate sold eventually at an advance. The bank may invest the funds deposited with it in government bonds. These always find a market, but their price fluctuates, and the bank might incur some loss in disposing of its holdings in order to meet the pressing demands of its depositors. Moreover, such bonds yield a very low rate of interest. The notes that are created in ordinary commercial trans- actions are one of the most satisfactory forms of bank investments. They are usually drawn for brief terms — thirty, sixty, or ninety days — and such notes are usually given in payment for goods which are salable in a rea- sonable time. Thus there is reason for believing that such notes can be met when due. If the depositors of a bank press for payment, so that the bank cannot await the maturity of the notes it holds, it can usually sell them to other banks and thus secure the means of immediate pay- ment. FINANCIAL INSTITUTIONS: THE BANK 291 In the United States national banks are limited by law to such investments as short term notes, bills of exchange, and government bonds. Investments in real estate, ex- cept for use in connection with the business operations of the bank, are prohibited. State banks are also more or less narrowly restricted in their investments. 11. Under modem conditions the greater part of the vol- ume of bank deposits arises out of the process of making loans. It has been assumed, in the foregoing sections, that the principal business of a bank is the lending of deposits intrusted to it in the form of spare cash. It is only under simple conditions that this is a fair representation of the business of a bank. In a modern industrial and Commercial city the deposits of cash represent a very small part of the volume of deposits that figure on the books of a bank. Let us suppose that a bank commences business with a capital of ;^ 100,000, consisting entirely of cash. Part of this sum — say ;^SOOO — is spent in acquiring a suitable building. The remaining $95,000 is held in the safe of the bank, to be loaned to business men who can offer adequate security. A manufacturer offers at the bank acceptable notes amounting to ;^ 10,000, and gets them discounted. He may, if he chooses, carry away with him the cash repre- sented by the discounted value of the notes. This, how- ever, he is not likely to do. What he wants the money for is to make purchases of materials, to pay salaries and wages, and to meet other business expenses. The most convenient method of payment is by checks drawn on the bank. So instead of carrying the money away from the bank he is likely to leave it as a deposit, subject to with- drawal on demand. Of course there is no reason why the bank should go through the form of counting out the cash to the manufacturer if it is to be redeposited in this way. 292 INTRODUCTION TO ECONOMICS What it does is to credit the manufacturer with a " deposit " equal to the discounted value of the notes which he lias transferred to it. Let us follow in imagination the history of the manu- facturer's deposit. In the course of a month he may draw checks aggregating a sum equal to the deposit credited to him in payment of wages and other expenses. These checks may be deposited with the bank by the manufac- turer's employees and the merchants who furnish materials and other supplies. The employees and merchants draw checks upon the bank to cover their expenses, but these checks may be redeposited. It is possible that the notes originally discounted will fall due and be paid before the bank is compelled to surrender any considerable amount of cash on account of the loan which it made in discounting the notes. Let us suppose that the bank has discounted notes amounting to ^95,000 — -a sum equal to its original cash holdings. In discounting these notes the bank has credited its customers with deposits amounting, we will say, to $94,000. As these deposits are drawn upon, the checks drawn are largely deposited with the bank under other accounts. Very likely not more than $4000 out of the $94,000 in deposits is withdrawn from the bank in the form of cash. We see, then, that if the bank were to limit its loans to the amount of cash actually on hand, the greater part of this cash would remain in the bank idle. Accordingly, it is natural that the bank should try to get a return from its cash by making additional loans. If it lends $200,000 on a basis of $95,000 in cash, crediting the borrowers with deposits amounting to $195,000, the chances are that a larger amount of cash will be withdrawn by depositors than if its loans amounted to $95,000 and the deposits to $94,000. Yet the withdrawals of cash may amount to only $15,000, leaving the bank still with a large FINANCIAL INSTITUTIONS: THE BANK 293 amount of idle cash. It can safely increase the volume of its loans and the resultant deposits. As the volume of deposits increases, a point must eventually be reached where the cash on hand is just sufficient to meet all prob- able demands for cash. At this point the bank must cease to make further loans. 12. Every bank receives in the course of its business checks drawn upon other banks. Through the clearing system the checks received by a bank are balanced against checks drawn upon it and deposited with other banks, so that little cash is withdrawn from it in the settlement of claims of other banks. One reason why a bank can extend its loans far beyond the volume of the cash in its possession is that checks drawn upon it are likely to be deposited with it, instead of being cashed. If checks drawn upon one bank are de- posited with another bank, withdrawal of cash would appear to be inevitable, since one bank does not, except under special circumstances, keep a deposit with another bank. Let us assume that in a town there are several banks which we may designate as A, B, C, etc. Some of the citizens of the town will deposit their funds with bank A, some with B, some with C. Often a man will use his check, drawn on bank A, in making a payment to a man who keeps his deposit with bank B or C. The recipient of the check might of course take the check to bank A, obtain cash for it, and deposit the money with his own bank. It is more convenient, however, for him to transfer the check, by indorsement, to his own bank. The bank then credits him with the sum represented by the check, and assumes the trouble of collecting the sum from bank A. And so every day, we may suppose, checks drawn on bank A are deposited with banks B and C ; checks drawn on these banks are deposited with bank A. At the end of 294 INTRODUCTION TO ECONOMICS eaph business day a clerk in the employ of bank A takes the checks drawn on B and C and presents them for payment at those banks. Similarly a clerk from bank B presents for payment checks deposited with that bank, drawn upon A and C. One can easily see that such a method of settle- ment involves some waste of energy. While a clerk of bank A is presenting for payment at bank B checks drawn upon that bank, a clerk of bank B is presenting for pay- ment at bank A checks drawn upon the latter bank. Money is being carried from A to B at the same time that money is carried from B to A. Obviously some method of balancing can be devised which will save the unnecessary labor and risk of thus carrying money to and fro. Espe- cially would this be necessary in a large city, where there are scores of banks. In every important center the banks form an association which provides a building or a hall known as a clearing house, where representatives of the several banks meet daily for the settlement of the claims of each' bank upon the other banks. The claims of each bank upon all the others are set off against the claims of all the other banks upon it. When this has been done, it will be found that some of the banks have a balance in their favor, while others have a deficit to make good. Each debtor bank then pays a single lump sum representing its indebtedness to all the associated banks ; each creditor bank receives a lump sum represent- ing the balance of its claims upon all the banks. By this method the transfer of cash from bank to bank is reduced to the lowest terms. 13. The cash kept on hand by a bank to meet probable cash demands is known as the reserve. In many cases the laws regulating banking require the banks to maintain re- serves amounting to a certain proportion of the deposits and other demand liabilities. If banks are free to extend their loans at will, the amount FINANCIAL INSTITUTIONS: THE BANK 295 of cash kept on hand to meet the possible demands of the depositors will vary according to the banking habits of the business community and the temperament of the bankers. In highly developed commercial communities, very little cash is used in effecting exchanges; reliance is placed upon the use of checks. In such a community a bank may extend its loans, and the attendant volume of its de- posits, almost without definite limit. If it keeps on hand i^io in cash for every $100 of deposits, it will probably be able to meet all cash demands without difficulty. Banks have been known to conduct a successful business with only 1^5 in reserve for every ;?ioo of deposits. The smaller the proportion of the reserve to the de- posits, however, the greater the chance that a bank will be unable to meet demands for cash from its depositors and other creditors. Failure to meet such demands may cause great embarrassment to the customers of the bank. If a man cannot draw upon his bank deposit, very likely he will be unable to meet his own obligations ; his creditors, in turn, are embarrassed in meeting their obligations, and so the evil extends in ever widening circles throughout the business community. The depositors of other banks, fear- ing that their banks will likewise fail to pay cash on de- mand, withdraw their deposits until, at times, it becomes impossible for those banks to continue to pay cash. It is natural that legislatures should attempt to reduce the chances of such a calamity by regulating the business of the banks. A favorite device is to fix by law a mini- mum reserve to be maintained by each bank against its deposits. In the United States, banks organized under federal laws are required to keep reserves amounting to fifteen per cent of the deposits in the lesser cities, and to twenty-five per cent of the deposits in the larger cities. Banks organized under state laws are required to keep re- serves amounting to from ten to twenty-five per cent. 296 INTRODUCTION TO ECONOMICS 14. The chances of ultimate loss to the depositor of a well conducted bank are very small. It may seem that even when a bank keeps a reserve amounting to twenty-five per cent of its deposits, the deposi- tor is in danger of loss. What if more than twenty-five per cent of the deposits should be demanded on any one day } The bank would, of course, be unable to make payment immediately. If a bank is not grossly mismanaged, it has property worth at least one dollar for every dollar figuring in its deposits. When it makes a loan of ^10,000, thus creating a deposit amounting, we will say, to ^9700, it receives from the borrower notes amounting to ;^io,ooo, which must be set against the $9700 which it owes its depositors. If the notes are good, at their maturity the bank will re- ceive more than enough cash to cancel the deposits created when the loan was made. Every part of the volume of deposits is covered in this way by notes, bills of exchange, etc., in the vault of the bank. These notes, etc., usually run for short periods, seldom extending over six months, and frequently maturing in less than thirty days. Even if the bank fails to meet its obliga- tions on demand, the worst that the depositor usually has to fear is that he will have to wait some weeks or months until the bank can collect the sums due it. But suppose that the notes in the bank's vaults are worth- less; that the bank will be unable to collect the sums due. In that case, the bank's own capital must be used to meet the claims of the depositors. If the volume of worthless notes exceeds the amount of the bank's capital, then the depositor may suffer loss. It is, however, rarely the case that a bank, discounts any large number of worthless notes. A bank accepts only such notes as there is reason to believe are good. Bank officials are in an excellent position to judge of the business FINANCIAL INSTITUTIONS: THE BANK 297 standing of the bank's customers. Checks used by these customers in payment of their obligations pass through the bank ; checks received by them are deposited with the bank. Thus it becomes fairly easy for competent bank officials to ascertain whether a business man is prospering, or operating at a loss. In the latter case, the bank forces the payment of notes when due, and refuses to make new loans. Thus bank loans are, as a rule, restricted to those members of the business community who are able to keep themselves in a position to pay their debts. In some instances, to be sure, banks are ruined through fraud. Bank officials may embezzle the funds or may extend loans to personal friends to be employed in risky ventures which result in total loss. The laws of most states are stringent enough to reduce losses through fraud to a minimum. 15. Bmik notes are claims upon the bank that are essen- tially of the same nature as deposits. In the foregoing discussion it has been assumed that the transfer of claims upon the bank is made through checks, drawn upon a deposit, and redeposited by the holder. A man who receives a check may, however, transfer it, prop- erly indorsed, to another man, who in turn may transfer the check to a third person. Each holder of the check becomes in turn the creditor of the bank. When the check is at last deposited with the bank, the claim upon the bank is formally transferred on its books. But it is obvious that the claim on the bank is just as certainly transferred when- ever the check changes hands. Such a check could not pass through many hands, be- cause only those persons knowing the credit of the drawer would be willing to accept it. There are men who draw checks on banks where they keep no deposit; if you are offered a check drawn by some one you have never heard of, how do you know that it will be honored by the bank .'' 298 INTRODUCTION TO ECONOMICS A person wishing to use checks as a means of payment among persons who are not certain of his credit may take the checks to the bank and have the cashier certify upon their face that they represent a deposit, and will be honored by the bank. Such checks — known as certified checks — may circulate as freely as money in the community where the bank's standing is known. It is clear, however, that a certified check is a claim upon the bank of the same nature as an ordinary check drawn upon a deposit. Instead of certifying checks drawn upon a deposit, the bank may give the customer who wishes means of ready payment a parcel of its own notes, payable to the bearer on demand. The customer is then the creditor of the bank for the amounts stated in the bank notes in his possession. As soon as he uses the notes for the purchase of supplies, etc., he transfers the claim upon the bank to the seller of the supplies. Such notes may pass from hand to hand for years, each successive holder of a note becoming the cred- itor of the bank. Obviously it makes little difference to the bank whether a business man who discounts a note is credited with a de- posit on the books of the bank or takes the bank's notes in the same sum. The deposit represents a right to cash on demand ; the bank notes represent exactly the same thing. The deposit may pass from owner to owner through checks drawn upon it and redeposited with the bank ; the note passes from owner to owner without the formality of a transfer on the books of the bank. Any one of the series of owners of the deposit may demand cash at any time ; the same is true of any one of the series of holders of a bank note. For some classes of transactions, it is true, a deposit subject to check is the more convenient means of payment, while for other classes of transactions bank notes are the more convenient. 16. The issue of bank notes is usually hedged about by FINANCIAL INSTITUTIONS: THE BANK 299 legal restrictions designed to protect the note holder from loss. The issue of bank notes is usually carefully regulated by government, so as to safeguard the holder of notes against loss. Now, we have seen that the positions of the note holder and the depositor are analogous. Both are creditors of the bank; both have a right to cash on de- mand. Why then should the government take greater pains to insure the note holder against loss than to insure the depositor ? The depositor usually lives in the city in which the bank which holds his funds on deposit is established. He is therefore in a position to know something of the standing of the bank. If he has reason to believe that the bank is not well managed, he can at once withdraw his deposit. On the other hand, bank notes often find their way to distant cities. The holders of such notes can know nothing about the credit of the issuing bank. For this reason it is only just that their interests should be protected by the govern- ment. Various methods are employed by the different govern- ments to protect the note holder against loss. In some countries the volume of notes that a bank may issue is limited to a certain proportion of the capital of the bank ; in case of failure the note holders have a prior claim upon all the resources of the bank ; furthermore, each bank is re- quired to contribute to a fund for the immediate payment of notes of banks that have failed. In the United States na- tional banks alone have the privilege of issuing notes ; other banks may indeed issue notes, but are taxed so heavily on their notes that issue is unprofitable. A national bank which avails itself of the privilege of issue must pur- chase, and deposit with the United States Treasury, United States bonds the par value and the market value of which is equal to the value of the notes issued. In case the bank 300 INTRODUCTION TO ECONOMICS fails, these bonds are sold, and the proceeds used to redeem the notes. Thus it is quite impossible for the holder of bank notes to suffer loss, even if the bank of issue fails. 17. Bank notes and bank deposits serve as currency, and reduce the amount of money needed for effecting exchanges. In the United States bank notes are used in effecting exchanges in the same way that money is used. Every one knows that the note holder is absolutely insured against loss ; consequently no one takes the trouble to present bank notes at the issuing bank for redemption in money. Were the issue of bank notes prohibited, a large volume of exchanges now effected through their use would have to be effected by means of money. We should need a much larger amount of money than we now possess to carry on the existing business of the country. Bank deposits serve in a similar way as a means of effecting exchanges. A deposit, we have seen, is not a definite sum of actual money, kept safe in the vaults of a bank. It is a right to demand money at the bank. When a man pays for goods by means of a check drawn on such a deposit, he simply transfers his claim upon the bank. Such a claim may be transferred again and again, effecting scores of exchanges. It has been estimated that in the great commercial cen- ters of the United States fully ninety-five per cent of the total volume of purchases and sales is effected by means of the transfer of claims upon banks. Money plays a rela- tively more important part in the lesser towns and the rural districts ; yet even here it is probable that bank notes and deposits effect a larger volume of exchanges than does actual money. 18. Summary. The principal function of finance is the transfer of capi- tal to those who can use it most advantageously. The transfer of capital usually assumes the form of a loan. FINANCIAL INSTITUTIONS r THE BANK 301 either recognized as such, or disguised under the form of a credit sale. We may look upon the lending of capital as the purchase of such credit instruments as the promissory notes given by borrowers. The function of the bank is primarily the borrowing of sums of capital available for short periods of time and the investment of such sums in short term credit instruments. The sums borrowed by the bank are known as " deposits " ; the investments of the bank, since they represent for the most part the face value of the credit instruments pur- chased less interest to maturity, are known as " discounts." In practice, when a business man sells a note to a bank, he leaves the proceeds of the note as a " deposit " in the bank, subject to withdrawal by check. In modern banks by far the greater part of the volume of deposits is created in this way, and not by the deposit of cash. While the bank is compelled to pay out its deposits on the demand of the depositor, it is rarely the case that many depositors demand cash at any one time. This is partly due to the convenience of payment by means of checks. A depositor who wishes to make a payment draws a check in favor of his creditor ; and this check is likely to be deposited in the bank by the payee ; thus the payment is effected without any withdrawal of cash from the bank. Through the system of- clearing each bank is protected against serious drains upon its cash holdings through checks drawn upon it and deposited in other banks. While little cash is ordinarily withdrawn from a bank, under ordinary circumstances, it is nevertheless necessary for a bank to keep on hand a considerable amount of cash, to safeguard itself against unexpected demands. The cash thus kept on hand is known as the reserve. The amount of the reserve should bear a proportion to the deposits which varies according to the character of the community in which the business is carried on. In the United States 302 INTRODUCTION TO ECONOMICS a minimum reserve is prescribed by law. The ultimate solvency of a bank does not depend upon its reserve, but upon the character of the notes in which the bank invests its funds. These are, as a rule, sound, and the chances of bank failure, except through fraud, are small. The notes issued by banks are demand liabilities not essentially different from deposits. Since notes wander far from the bank of issue and are offered in payment to persons who can know nothing of the credit of the issuing bank, special regulations are adopted by governments to insure their payment. Bank notes and bank deposits fulfill the functions of cur- rency. The amount of money necessary for carrying on exchanges is greatly reduced by the use of a deposit and note currency. CHAPTER XVII OTHER FINANCIAL INSTITUTIONS 1. The making of permanent and long term, investments may be regarded as the flow of funds from the capitalist class to the enterpriser class. The chief function of the bank, as we have seen, is the supplying of the demand for short term loans, through the accumulation and placing of capital which is available for use for short periods of time. The creditors of a bank and its debtors are, as a rule, members of the same eco- nomic class — men actively engaged in trade and industry. Each man is, in turn, borrower and lender. In the pres- ent chapter we are concerned with the investment of funds in credit instruments that run for long terms, or are per- haps even perpetual. It is plain that we are here dealing with the relations of two fairly distinct economic classes. Men who, for one reason or another, take no active part in business, place their funds with active business men. The former class corresponds roughly with the capitalistic class of economic theory, the latter, with the enterpriser class. We may, therefore, regard the placing of capital in permanent and long term investments as a flow of funds from the capitalist to the enterpriser. 2. The principal sources of demand for long term invest- ment funds are (i) the purchase and improvement of real estate ; (2) the financing of large corporations ; and (3) the extraordinary needs of government. Throughout the country there is a constant demand for capital for the purchase and improvement of real estate. Men with small capitals of their own desire, to buy farms or building lots ; men who possess land desire to prepare 304 INTRODUCTION TO ECONOMICS it for cultivation or to equip it with the necessary stock or buildings. Those with insufficient capital — and they are many — enter the capital market as borrowers. They ex- pect such capital as they may raise through loans to be highly productive, but they cannot be sure that they will be able to restore it to the lenders for several years. To meet the needs of such borrowers, lenders must surrender control of their funds for a considerable period of time — five, ten, or fifteen years. A second source of demand for capital arises from the needs of the modern large scale business enterprise. In many forms of business the capital necessary for effective operation exceeds the amount that an ordinary enterpriser owns, or can raise through personal loans. The number of million-dollar enterprises in the United States vastly exceeds the number of millionaires. Accordingly, it is necessary to transfer to a single active enterpriser the capitals accumulated by numerous individuals. A third source of demand for capital — and the last with which we need concern ourselves — ■ arises from the extraor- dinary needs of government. Under ordinary circum- stances the expenditures of most governments are met by current revenues. Owing to unforeseen circumstances, revenues may be less than were anticipated, while expen- ditures may prove unusually heavy. As it takes time to revise a revenue system, a considerable deficit may appear, which involves borrowing under one form or another. A much more important cause of public borrowing is the enormous expense entailed by modern warfare. No great war can be carried to a successful issue without the em- ployment of far greater resources than any practicable system of taxation will afford. Recourse must therefore be had to loans. Government loans thus arising cannot quickly be paid off. Often loans are negotiated for ten, twenty, or thirty years ; and even at the expiration of the OTHER FINANCIAL INSTITUTIONS 305 period for which they are contracted, they are frequently paid out of the proceeds of new loans. The greater part of the public debt of the United States dates from the Civil War ; a large part of the debt of Great Britain had its origin in the Napoleonic wars. Again, governments may borrow money for the purpose of carrying out a policy of permanent improvements. The United States, for example, raises the funds for the con- struction of the Isthmian Canal through loans. The Prussian, Russian, Indian, and Australian governments have borrowed vast sums for the purpose of purchasing and constructing railways. Cities are continually borrow- ing money for similar purposes. Especially where the policy of municipal ownership finds favor, the demand for capital for public use is enormous. 3. The principal sources of supply of capital for long term investments are: (\) private fortunes accumulated in business, whose possessors desire freedom from, the labors of active management ; (2) the funds of endowed institu- tions; (3) the funds accum.ulated from, private incomes and kept as a reserve against contingencies. Just as there are always men who are entering business life, so there are always men who are retiring from active business affairs. Men of the latter class desire to obtain an income from their accumulations without the labor that personal management entails. Universities, hospitals, and other institutions receive money endowments, which must be invested in such a way as to yield a steady income. Wage-earners and professional men are under the necessity of putting by a part of their incomes as a reserve against sickness and old age, or as a provision for their dependents in case of death. Capitalists who look forward to increasing burdens save some part of their interest receipts ; active business men save part of their profits. Of these savings some part is reinvested in their own business by the men 3o6 INTRODUCTION TO ECONOMICS who save. A great part of the total fund of savings must, however, be placed under the control of other persons, if it is to yield a considerable income. We have now a view of the work that the financial mechan- ism must perform. It must gather together the funds of free capital and place them under the control of those who can make best use of such funds. We may next proceed to a study of the methods by which this work of placing capital is performed. 4. The typical instruments employed in the effecting of long term and permanent investments are mortgage notes, bonds, and stocks. The transfer of capital for long terms implies the creation of various instruments which serve as evidence of the claims of the capitalist. The simplest type of such instruments is the promissory note secured by the pledge of property, such as houses and lands. Where the sum to be raised by a loan is very great, as in the case of corporation loans, the resources of numerous lenders must be drawn upon. Instead of executing a great number of separate notes, representing the amount borrowed from each person, the corporation may execute a note, secured by the pledge of property, covering the whole sum, and deposit it with a trustee. The trustee then prepares certificates represent- ing shares in the loan, and delivers them to lenders as evidence of the sums loaned. Such certificates are known as "bonds." A government may issue similar certificates of indebtedness without executing a note representing the entire loan. Such bonds are seldom secured by the pledge of property. In any case it is clear that govern- ment and corporation bonds are merely forms of promissory notes. Instead of raising money through an issue of bonds, a corporation may sell shares of stock which entitle the owner not only to an income, but to a share in the manage- OTHER FINANCIAL INSTITUTIONS 307 ment of the enterprise. In law the position of the stock- holder is very different from that of the bondholder. The former is a partner in the business undertaking ; the latter is a creditor of it. In practical life the ordinary stock- holder has little to do with the control of a corporation. He purchases stocks for the income they yield, just as he would purchase bonds for their income. The bondholder is a preferred claimant ; therefore bonds, as a rule, offer a more certain income. The different classes of bonds vary widely in security, however, and many are inferior to certain classes of stocks in this respect. Such instruments — promissory notes, bonds, and stocks — are clearly not capital, but merely evidence of owner- ship of capital. We may, however, think of the purchase and sale of such instruments as the purchase and sale of capital, since the ownership of the underlying productive goods is transferred with the transfer of such instruments. For convenience we may speak of notes, bonds, and stocks as " investments." Bonds and stocks are commonly called "securities." 5. Investments vary greatly in respect to security. Investments of this character, as has been said, differ widely in security. The long term notes of business men are usually secured by the pledge of tangible property of some kind, but the property pledged may represent a more or a less adequate guaranty of repayment. A loan secured by the pledge of land in a semi-arid region is not so safe as a loan secured by the pledge of land in a locality where crop failures are unknown. A series of dry years may depopulate a semi-arid district, and practically destroy the value of land there. Loans secured by suburban real estate are not, as a rule, so safe as loans secured by busi- ness property in the heart of a city. The bonds of a govern- ment like that of the United States are generally regarded as safer investments than those of Japan ; the bonds of the lat- 3o8 INTRODUCTION TO ECONOMICS ter country are safer than those of Guatemala or Venezuela. Corporation bonds similarly vary widely in security. Ex- perience has shown that corporations frequently become bankrupt, and in such cases the bondholders may lose part or all of their invested capital. Stocks, as a rule, are yet more uncertain investments. When a new interurban railway is constructed, no one knows certainly that the business which it will carry on will yield a fair return on the capi- tal invested ; if it does not do this, dividends on its stock will be low. Even in the case of an established business, changed conditions may annihilate profits and cause a suspension of dividend payments. 6. Investments vary in their transferability. Suppose that an investor in New York holds a note secured by a mortgage on a farm in one of the western states. In some of the states such a note is not transfer- able at all. Even if the laws are such as to permit the sale of the note to a third party, the holder would find difficulty in disposing of it. The buyer would need to know some- thing of the value of the property pledged as security and this he might be unable to ascertain without examining it himself. The bonds of a small manufacturing or mercan- tile corporation in one of the minor cities would more easily find buyers in distant financial centers. Even these, how- ever, would ordinarily be difficult to dispose of. The bonds of a great railway or of an industrial consolidation always find a ready sale. One who invests in a Pennsylvania Railway or a United States Steel Corporation bond knows that he can at any time find some one who will be ready to buy it from him. 7. The productiveness of an investment is measured by the ratio between its return and its market value. Different classes of investments vary widely in productiveness. It is, perhaps, straining the meaning of words to speak of a mortgage note or a corporation bond as being " pro- OTHER FINANCIAL INSTITUTIONS 309 ductive." There is, however, reason to distinguish between the securities that yield an income and those that yield none, and the business world has drafted the words " pro- ductive " and " unproductive " into this service. We may safely accept the terms, as we are in no danger of falling into the error of regarding notes and bonds as actually pro- ductive, in the physical sense of the term. We must distinguish between nominal productiveness and real productiveness. A bond of $100 face value may yield $4 per annum. The nominal productiveness of capi- tal invested in such a bond is four per cent. But per- haps the bond may be purchased in the market for $80. In such case the real productiveness of capital invested in the bond is five per cent. A ^100 share of stock paying dividends of ten per cent on its par value may sell at ^200. The real productiveness of capital invested in such a stock is no greater than that of capital invested in the four per cent bond. We need not concern ourselves here with nominal pro- ductiveness. Whether such productiveness is high or low is a matter dependent upon the volume of securities cover- ing a specific earning power, and this volume is arbitrarily fixed. Real productiveness varies widely. Some invest- ments yield only two per cent ; some yield ten per cent or even more. 8. Tke principal cause of variation in the productiveness of investments is risk, real or imagined. The bonds issued by the United States government yield less than two per cent on the capital represented by their market value. Bonds issued by the government of Santo Domingo, before the time of American intervention in the affairs of that country, often yielded as much as twelve per cent on their market value. Practically the only reason for the great difference in productiveness was the difference in security. The bonds of the several states 3IO INTRODUCTION TO ECONOMICS vary considerably in productiveness, and the bonds of municipalities display yet greater variety. The greatest variations in productiveness are to be found in corporation stocks, for here risk is greater than in the case of most classes of bonds. Although there may be no real difference in risk between two investments, if it is commonly believed that there is such a difference, this behef is reflected in the productive- ness of the respective investments. The bonds of Japan may be as safe as those of the United States ; but this is not generally believed to be true. For this reason invest- ments in Japanese bonds are more than twice as productive as investments in United States bonds. 9. The productiveness of investments varies with their de- gree of transferability. As a rule, the greater the transferability of a form of investment, the lower will be its productiveness. Few in- vestors are absolutely certain that they will not at some time desire to regain control of their funds. They will therefore take at par a bond that is easily disposed of rather than one of equal security and equal nominal pro- ductiveness which they might find difficulty in selling. Consequently, the price of bonds of the former class will generally be higher than that of bonds of the latter class. A hundred dollars invested in the former class of bonds will yield a lower rate of interest than a hundred dollars invested in the latter class. The bonds of a great industrial corporation are usually less productive than those of a small one, on account of the greater transferability of the securities of a well-known business concern. Most classes of bonds furnish less pro- ductive investments than small real estate mortgages, be- cause the latter can with difficulty be transferred. 10. The placing of capital may be effected by direct arrange- ments between tlie capitalist and the enterpriser or through OTHER FINANCIAL INSTITUTIONS 311 Where economic conditions are simple, as in an agricul- tural district or in a small town, the placing of capital may be effected through direct arrangements between those who need capital and those who have it to spare. The moral character and business capacity of an enterpriser is easily ascertained by those who wish to place their capital. A man who wishes to borrow capital can easily establish re- lations with those who have capital to lend. Even in such simple conditions, however, the individual borrower or lender is often at a disadvantage. The former may fail to meet the men who are ready to lend at the lowest interest rate ; the latter may fail to find the safest and most pro- ductive investments for his capital. Hence the need for a middleman, to bring together borrower and lender, enter- priser and capitalist. As industrial conditions become more complex, the need for the middleman becomes more in- tense. It would be quite impossible for the small capitalist of a city like New York or London to search out the most productive investments afforded by the business of such a city, were there no men who made it their business to bring capitalist and enterpriser together. The men who perform this function may employ either of two methods. They may act as mere agents, in behalf of lender or of borrower or of both. Thus in some towns there are men who undertake, for a fee or " commission," to place any man who wishes to borrow in relations with men who have capital to lend. The function may, how- ever, be performed in another way. Men with some capi- tal of their own may hold themselves in readiness to borrow any capital that is offered for a definite period of time, trusting to the chance that they will be able to lend it again on more advantageous terms. The difference be- tween the interest received and the interest paid represents the profits of the middleman. This, we have seen, is the method employed by the bank in its proper field. 312 INTRODUCTION TO ECONOMICS The distinction which we have drawn between the two methods of placing, or marketing, capital, finds its ana- logue, we readily see, in a similar distinction in the methods of marketing commodities. A manufacturer may employ an agent, at a fixed commission, to bring his wares before the consuming public, or he may sell them to a merchant, who undertakes the responsibility of disposing of them to consumers. 11. In the great modern commercial centers the placing of capital is effected largely through the stock exchanges — mar- kets for the purchase and sale of securities. Under modern conditions an enormous amount of capi- tal is represented by the bonds of nations, states, and mu- nicipalities and of private corporations, as well as by the stocks of corporations. A government may issue several hundred millions in bonds, all yielding the same return and having the same security, and private corporation issues of bonds and stocks are sometimes of equal magni- tude. A person wishing to invest in a particular issue of government or corporation securities leaves an order with a broker to purchase such securities for him. A person wishing to regain control of capital invested in securities leaves them with a broker with orders to sell them. Natu- rally, the brokers dealing in stocks and bonds establish the custom of meeting at a fixed place, where those who have orders to buy may meet those who have orders to sell. Such a meeting-place, or market, is known as a stock exchange. For convenience, each exchange makes rules which brokers doing business there must observe. In their details these rules do not concern us here ; in principle they are designed to insure effectiveness and fair dealing. 12. Since securities dealt in on the exchanges fluctuate in value, profits may be secured through buying when such se- curities are cheap and selling them when dear. Business of this )iature is termed speculation. OTHER FINANCIAL INSTITUTIONS 313 Practically all the securities dealt in on the exchanges are constantly fluctuating in price. The bonds of a country like the United States are unusually stable in value, yet a hundred-dollar bond is somewhat cheaper at one time than at another. If the United States should become involved in a war, the price of its bonds would decline, because of the probability of new issues. Even the rumor of a war, how- ever slight its foundation, may affect adversely the price of a nation's bonds. The bonds of a city may decline in value if the city government announces its intention of undertak- ing improvements on a large scale. The price of bonds of railway and industrial corporations is affected by every change in business conditions. Price fluctuation is still more common in the case of stocks. It is n ot unusual for the price of a given stock to decline from ^150 per share to ^60 per share within a single year. Suppose that a company has been formed to exploit gold mines in Alaska. Its shares are offered on the market ; we have read glowing accounts of the prospects of the company, but whether these ac- counts are reliable or not we cannot say. The company may earn enough to pay enormous dividends ; it may earn nothing. What is more natural than that opinion as to the value of the stock should undergo frequent changes, and that the price of the stock should fluctuate accordingly. In view of the constant fluctuation in securities, it is natural that some men should make it their business to buy stocks when they appear to be cheap, with the purpose of selling them when prices rise. This is one of the numer- ous forms of speculation. The buyers of stocks and bonds are commonly divided into two classes — investors and specu- lators. The former class buy chiefly with the purpose of enjoying a permanent income from the securities purchased ; the latter, chiefly with the hope of profiting from a rise in price of the securities. 13. The speculator provides enterprises which have not 314 INTRODUCTION TO ECONOMICS yet demonstrated their power to yield an income with the capital necessary for carrying on business. Naturally, the speculative buyer deals commonly in the securities that show great fluctuations in price, while the investor prefers the securities that have a comparatively steady price. Now, it is the securities of new companies that are most likely to fluctuate in value. After a com- pany has been in operation for a number of years, its nor- mal earning power becomes established, and the real value of its securities becomes fairly well settled. Thus there is a constant progress of securities from the speculative class to the investment class. We can now see what one of the economic functions of stock speculation must be. So long as the success of a company is in doubt, the cautious investor will have noth- ing to do with it. Men who are willing to take risks — speculators — buy the securities of such a company, with the expectation of selling them later at a profit. In so do- ing they furnish the company with the funds necessary for carrying on business operations. If the company succeeds, and demonstrates its power to produce a large and steady income, its securities acquire a stability of value fitting them for purposes of permanent investment. The specu- lators, in such cases, gain large profits. If the company is a failure, the speculator bears the loss. It is of course true that stock speculation offers great opportunities for sharp practice. A group of speculators holding the stock of a gold-mining company may succeed in placing in circulation deceptive accounts of the prospects of the company, and so manage to dispose of their holdings to the unwary at unreasonably high prices. A group of speculators, desiring to purchase certain stocks at a low price, may circulate rumors of impending disaster, and so create a panic among holders of stocks. Nevertheless, it is to be borne in mind that the speculative buyer of stocks per- OTHER FINANCIAL INSTITUTIONS 315 forms a very important economic function in furnishing capital for enterprises the success of which is still in doubt, but which may eventually prove to be highly profitable. The speculator stands in the position of a middleman be- tween the company which needs capital and the cautious investor. 14. When a company seeks to raise capital through an issue of securities, it may place orders with brokers to sell the securities for what they will fetch, or it may m,ake, with an association of wealthy persons, an agreement accord- ing to the terms of which the association assumes responsi- bility for the sale of the securities at a definite price. Such an association is called an underwriting syndicate. Let us suppose that a great railway desires to raise about ^50,000,000 by a new issue of four per cent bonds. It may place orders with brokers to sell the bonds at what- ever price they will command. The bonds of the railway which are already outstanding may be selling above par, but no one can say exactly what effect on the price of bonds the new issue will have. Possibly the bonds will be taken by investors at par; possibly the price will fall to ;?8s per hundred dollar bond. Moreover, it may take a long time before all the bonds are taken by speculators or investors. The railway company, however, desires a definite amount of capital at a definite time, and cannot afford to experiment. So its agents may make an arrange- ment with a group of financiers whereby the latter agree to insure the sale of the entire issue at ;^9S per hundred dollar bond. The bonds are then placed on sale at, say, ;^ioo. If the investing public takes the bonds at this price, the group of financiers, or "underwriting syndicate," gains a profit equal to the difference between the price to the public and the price agreed upon between the railway company and the syndicate. If the public refuses to buy, the syndicate is compelled to take the issue of bonds at 3i6 INTRODUCTION TO ECONOMICS the price agreed upon — 1^95. Possibly the syndicate will be able to dispose of the bonds later on favorable terms ; possibly it will in the end be compelled to sell them at less than the price it has paid. Where the securities underwritten by a syndicate are of a more speculative character, as for example the stocks of a new industrial corporation, the difference between the price placed upon securities offered to the public and the price to the syndicate is much greater. The possible profits of the syndicate are much greater ; but so also are the pos- sible losses. 15. A71 investment company is a company which purchases and holds stocks, bonds, mortgages, etc., the income of which is distributed as dividends among its own shareholders. A company may be formed for the sole purpose of deal- ing in the securities of other companies. Such a company — which we may call an investment company — places its stock upon the market, and invests the proceeds of the sales of such stock in the stocks and bonds of banking, railway, franchise, and industrial corporations, in government bonds, or in real estate mortgages. The interest and dividends from such investments makeup the gross profits of the investment com- pany. From these profits are deducted the expenses of ad- ministering the company ; the remainder may be distributed among its stockholders as dividends. The advantages of such a company are obvious. It can employ men who are thoroughly famihar with the securities market to purchase stocks and bonds when the condition of the market is favorable. Since it purchases on a larger scale than the ordinary investor, it may participate in underwriting syndi- cates, and so obtain securities at a lower price than the outside investor must pay. It may distribute its invest- ments so that when some of them fail to yield the expected returns, others may yield unusually large returns. Thus the stockholders of the investment company are made OTHER FINANCIAL INSTITUTIONS 317 more certain of a steady income than they would be if they invested their funds directly. Further, the investment company may deal in securities of undoubted value, which are nevertheless not well enough known to be easily transferred. There is no reason why the investment company should ever part with such securities. It may purchase mortgage notes which never would find a purchaser on the general market. As we have seen, the non-transferable investments yield, as a rule, higher returns than those that are easily transferred. Accordingly, the man who invests his funds through an investment company enjoys the higher income that non-transferable investments yield ; at the same time, he can at any time regain control of his funds through the sale of his stock in the investment company. From an economic point of view, the investment com- pany is a device which serves to direct capital to the more productive channels. In present-day business it has largely been diverted to another purpose, — that of stifling competi- tion. Let us suppose that in a given territory two railways are actively competing for business. Neither can charge as high rates as it could if it enjoyed a monopoly. Now, let us suppose that an investment company buys up a major- ity of the stock of both railways. It can then appoint the directors of both railways, and require them to adopt poli- cies which enable each to fix high charges for service. In this way the earnings of the railway companies, and hence of the investment company, are increased. Hostile federal legislation, it is true, has limited the efficacy of the invest- ment company as a means for destroying competition be- tween railways ; but the same device is widely employed in the case of manufacturing corporations. 16. The savings bank performs the same function for the small investor that the investment company performs for the large one. 3i8 INTRODUCTION TO ECONOMICS It is only persons possessing at least a moderate amount of free capital who can purchase with advantage investment company shares. Persons who have no other resource than their daily labor need to save some part of their income against sickness, old age, or unemployment; and these sav- ings should be placed where they may at once begin to earn interest. The artisan who saves $S a month cannot be expected to keep the money on his premises until he has accumulated enough to buy a share of stock. This would involve keeping part of his savings idle for perhaps twenty months. It would, moreover, expose such savings to the re- current temptation to spend. Hence the need of an institu- tion which will accept savings deposits, however small, pay- ing interest on them from the beginning, and which will return them to the depositor upon reasonable notice. Such an institution is the savings bank. Unhke the commercial bank, described in the last chap- ter, the savings bank can depend upon a certain perma- nence of deposits. Men who intrust their funds to such an institution do so, as a rule, with the expectation of leaving them for an indefinite time, to earn interest. The rules under which a savings bank operates may of themselves insure a reasonable degree of permanence of deposits. De- positors are often required to give some days' or weeks' notice of intention to withdraw deposits. Furthermore, interest is usually allowed only at the end of six months' periods ; withdrawal at any time within such periods involves the forfeiture of accrued interest. Some part of the deposits of a savings bank must be kept as a cash reserve, to meet possible withdrawals, but this reserve need not be large. The remainder of the de- posits may be invested. State laws generally specify the classes of investments that a savings bank may make, with a view to insuring the depositor against loss through inse- cure investments. Real estate mortgages, federal, state. OTHER FINANCIAL INSTITUTIONS 319 and municipal bonds, are the favorite investments of such institutions. The real estate mortgages present the advan- tages of security and a high degree of productiveness; government bonds, while yielding low returns, are easily convertible into cash whenever an unusual volume of with- drawals renders this necessary. Savings banks may be organized as mutual associations, in which case all the profits from investments are distrib- uted among the depositors as interest. They may be organ- ized as joint stock associations; in such case the excess of earnings above stipulated interest to depositors is distrib- uted among the stockholders as dividends. The latter form of organization prevails in the West, the former in the East. In many foreign countries the place of the mutual savings bank is taken by municipal and postal savings banks. In general, it is recognized that the proper function of the savings bank is to promote thrift among the poorer classes, not to afford an opportunity for profit to the well-to-do. Hence the small depositor is frequently given the prefer- ence over the large depositor, receiving a higher rate of interest. In many cases the size of the individual deposit is narrowly limited. 17. The building and loan association is a form of invest- ment company which limits its field to small loans on real estate security. A financial institution which in some parts of the coun- try takes the place of the savings bank in promoting saving among the working classes is the building and loan associa- tion. Each member of the association purchases a certain number of shares of "stock," paying for them in monthly installments. If at any time he wishes to withdraw, the association returns to him the sums which he has paid in, with or without interest, according to the time that has elapsed since his first payment. If a member desires to build a house, he may borrow from the association a sum 320 INTRODUCTION TO ECONOMICS not exceeding the par value of the stock in the association which he holds. As security for the loan, he gives a mort- gage upon the house which he builds with the aid of the loan. He further binds himself to make monthly payments to the association which represent interest on the loan, plus some part of the principal. Without entering upon the details of the organization of such an association, we can see that its purpose is to collect sums of capital from persons of small means, with the purpose of loaning them to other persons of smair means who desire to own homes. The latter class pay the interest that the former class receive. 18. From the financial point of view, the life insurance company is a m.odified form, of investment company. The returns from investments are for the most part made over to the policy holders. One further institution requires notice here : the life insurance company.' From a financial point of view, the life insurance company is a device for accumulating sav- ings which shall be returned, not to the man who saves, but to his heirs at his demise. Some of the insured, it is true, die long before the sum of the premiums they have paid equals the sum that the insurance company has agreed to pay at their death. On the average, however, the insured live long enough so that their premiums, to- gether with the earnings of the capital which those pre- miums form, are at least equal to the sums which the insurance company pays out in death claims. It is obvious that in a country like the United States, where life insurance is exceedingly common, immense sums of money must be collected by the companies every year, to be held as a reserve against death claims. As the busi- ness of life insurance is steadily growing, the funds accu- mulated by these companies are also increasing. The annual receipts of practically every important life insur- OTHER FINANCIAL INSTITUTIONS 32] ance company exceed the annual disbursements. Accord ingly, a life insurance company may invest its fund; without much regard to the possibility of turning its invest ments into cash at short notice. It is important, however that the business should be conducted in a conservativt manner, since the failure of an insurance company woulc be a more widely felt calamity than the failure of almos any other business enterprise of equal magnitude. Th( loss would be borne in the end largely by the dependent of propertyless men. The reserves of life insurance companies are largel} invested in real estate mortgages, in state and municipa bonds, and in the bonds of railway, commercial, and in dustrial corporations. Stock investments have often beei made by insurance companies, but the practice is nov generally regarded with disfavor, since the values of stock: are likely to show a wide range of fluctuation. 19. The mechanism for bringing investor and enterprise, together necessarily becomes more complex as industria operations increase in magnitude. In a small village, the investor and the enterpriser enter in to direct relations with each other. In a larger town, fund; flow from the investor to the enterpriser through the inter mediation of a broker. In a great city funds flow fron the investor to the enterpriser through the intermediatioi of a series of brokers and a series of speculators ; of tei other functionaries, such as the underwriter and the in vestment company, insert themselves in the chain connect ing the two primary financial classes — the investor anc the enterpriser. We shall understand this flow of fund better if we construct a diagram representing it in all it complexity : — 322 INTRODUCTION TO ECONOMICS Stockholder Depositor Policy Holder t t Y Independent Investor Investment Co. Savings Bank Insurance Co. I (Broker) Y Speculator I (Broker) Underwriting Syndicate Industrial Enterprise In our diagram the broker is placed in parenthesis, be- cause he is nominally an agent for the investor or the speculator. The diagram is less complex than the reality, because it assumes that only one speculator figures in the chain, when in fact a security may pass from one specu- lator to another for years before its value becomes suffi- ciently stable to attract the interest of investors. 20. Summary. In modern economic society there is a constant flow of funds from the capitalist class to the enterpriser class. The purchase or improvement of real estate, the financing of large business enterprises, and the extraordinary needs of governments give rise to the demand for long term in- vestment ; men retiring from active business life, endowed institutions, and persons accumulating capital against future needs furnish the supply of such funds. This flow of capital may be represented as the purchase and sale of stocks, bonds, and mortgage notes. Long term investments vary widely in security and transferability. As a rule, the greater the degree of secur- ity and transferability, the less the productiveness of an investment. The placing of capital may be effected through direct arrangement between the capitalist and the enterpriser, OTHER FINANCIAL INSTITUTIONS 323 or through the intermediation of a broker or other middle- man. The broker may carry on his business independently, or he may join with other brokers in organizing a stock exchange. The purchasers of stocks and bonds may hold them for the income which they yield, or for a rise in price. In the former case the purchasers are classed as investors, in the latter, as speculators. When an enterprise is new, its securities are chiefly held by speculators ; when its business is well established, the securities are likely to pass into the hands of permanent investors. Thus the specula- tor appears in the light of an intermediary between the en- terpriser and the ultimate investor. Investment may be made through various institutions, instead of directly by the capitalist. The most important of these are the investment company, the savings bank, the building and loan association, and the life insurance company. These institutions are adapted to the peculiar needs of different classes of investors. They share in common the advantages of expert skill in the making of investments and of power to distribute investments in such a way as to minimize risk. CHAPTER XVIII INTERNATIONAL TRADE AND FOREIGN EXCHANGE 1. All permanent trade rests upon differences in produc- tive powers. From early modern times, when men first began to think systematically upon economic subjects, a great deal of attention has been bestowed upon the exchange of goods between persons living under different governments, or international trade. It was for a long time believed (and it is still widely believed) that such trade differs radically in its nature from trade that is carried on within the limits of a single country. While the latter, it is generally ad- mitted, is an unmixed good, and ought to be encouraged, or at any rate granted the most perfect freedom by govern- ment, the former, many believe, is often a doubtful blessing and ought to be closely scrutinized and regulated, and, under many circumstances, discouraged or even prohib- ited. Whether there is any justice in this distinction be- tween the two branches of trade is a question that we must defer to the next chapter. For the present, we are con- cerned with the conditions giving rise to international trade and the mechanism by which it is carried on. All permanent trade is based upon differences in char- acter of productive powers. To employ a simple example, drawn from the field of local trade, if A can make three pairs of shoes in a day while B can make only two, and B can cut two cords of wood in a day while A can cut only one, the basis for permanent trade between them exists. It will pay A to get all his wood from B, exchanging shoes for it. The assumed difference in character of productive powers may have originated in differences in natural apti- tudes or in differences in training. In either case the 324 INTERNATIONAL TRADE AND FOREIGN EXCHANGE 325 difference in productive powers is the essential basis of a continuous interchange of commodities. But suppose that A can not only make more shoes in a day than B can make, but can also cut more wood. Does this supposition preclude the possibility of a permanent in- terchange of products between A and B .■' Not at all. Suppose that A can make three pairs of shoes in a day or cut two cords of wood, while B can make only one pair of shoes, or cut only one cord of wood. With two days' work B can produce as much wood as A can with one ; with two days' work he cannot produce as many shoes as A can with one. Accordingly, it would pay him to offer A the product of a little more than two days of his own work at woodcutting, in exchange for the product of one day of A's work at making shoes. And it would pay A to accept the offer. B suffers under a disadvantage in either occu- pation, but his disadvantage is less in woodcutting than in shoemaking. A enjoys an advantage in either occupation, but his advantage is greater in shoemaking than in wood- cutting. Common sense, then, urges B to confine himself to cutting wood, A to making shoes. In the trade between inhabitants of one part of the earth's surface with those of another part, differences in personal aptitude and training of the kind assumed in the foregoing example are supplemented by differences of a more general nature. One region may have excellent min- eral deposits but lack fertile land for the growing of food ; another region may be quite devoid of minerals, but abun- dantly supplied with rich lands. In one region the char- acter of the population may be such as to fit it for kinds of work requiring skill and taste, but not such as to fit it for kinds of work requiring great muscular strength and endur- ance. In another region the population may be almost in- capable of acquiring taste and skill, although it is well fitted for labor demanding rude muscular power. Capital 326 INTRODUCTION TO ECONOMICS may be plentiful and cheap in one region and scarce and dear in another. In this case industries requiring vast capital can be operated to greater advantage in the former region than in the latter. Land may be plentiful in one region, relatively to the population, and scarce in another. Industries requiring an extensive use of land will find their natural habitat in the former region. The populations of two regions, though differing little in fundamental charac- ter, may differ widely in their attitude toward particular forms of toil. They possess different habits, or, more properly, traditions of workmanship, which fit the one better for one kind of labor, the other for another. So long as any of these differences persist, there is obviously reason why there should be differences in the industries of the two regions. With adequate means of communication, trade between the two regions naturally arises. 2. Economically considered, trade should be classified as local and interregional, not as domestic and international. The latter classification may, however, be regarded as practi- cally equivalent to the former. We have spoken of differences between regions, not differences between nations. From a purely economic point of view, trade is either local or interregional, not domestic or international. The trade between Belgium and the adjacent d^partements of France is economically of the same character as the trade between Rhode Island and Mas- sachusetts. The trade between California and Hawaii is of the same essential character as the trade between New York and Santo Domingo. From an economic point of view domestic trade is that which originates in such differ- ences in natural aptitudes and industrial training as may for a long time persist on the same soil. Differences in natural endowment, in general character of population, in rates of wages and interest, characterize interregional trade. As a rule, however, international trade is also interregional; INTERNATIONAL TRADE AND FOREIGN EXCHANGE 327 hence the principles that apply to the latter may without serious qualification be applied to the former. Since the classification of trade as domestic and international is widely used, we shall accept it, in spite of its inaccuracy, in the following pages. 3. Trade between two regions or nations may be based upon the fact that each one produces goods of a kind that cannot be produced within the boundaries of the other. In some cases the products of two regions are quite dis- similar. Neither region can produce the commodities which it receives from the other. Thus in the Middle Ages an important trade was carried on between Northern Europe and the Indies. The former region furnished furs and amber, the latter, spices and gems. A modern example of the same sort of trade is the exchange of iron and steel products for teas, coffee, and spices between England on the one hand, and the East Indies on the other. In general, the trade between countries in the temperate zone, on the one hand, and countries in the torrid zone, on the other, is largely of this character. Trade having this basis is nat- urally permanent ; with every reduction in costs of trans- portation it tends to increase. Decline in railway and ocean shipping charges places more and cheaper tropical products in our hands, and places more of our products in the hands of the inhabitants of the tropics. Furthermore, we are, as a people, gradually learning to appreciate the good qualities in tropical products that a short time ago we held in slight esteem ; and we may assume that a cor- responding evolution is taking place in the tastes of the in- habitants of the tropics. 4. Each one of two trading nations may be able to produce all classes of com,modities that are the objects of exchange be- tween them. In this case, the one is likely to enjoy greater relative advantages for the production of one class of com- modities, the other for the production of another class. 328 INTRODUCTION TO ECONOMICS More commonly one of the trading regions, or both, can produce both classes of commodities exchanged. The United States can produce both sugar and pork ; so also can Cuba. But the United States possesses exceptional ad- vantages for the production of pork ; for the production of sugar it is not especially well adapted. Cuba, on the other hand, has unsurpassed advantages for the production of sugar, but can produce pork with only a moderate degree of success. It is, therefore, natural that an exchange of prod- ucts between the two countries should take place. Were there no artificial hindrances to such exchange, we should adjust our production in such a way as to produce all the pork that Cuba needs, and Cuba would devote more of her productive resources to the growing of sugar for our consumption. 5. Trade based upon differences in productive power aris- ing from differences in the character of two populations is permanent in character and tends to increase with improve- ments in transportation. Among the conditions upon which international trade is based, we mentioned differences in the essential character of the populations of trading regions. Such differences in character are difficult to define, since the characters of nations, as of individuals, are always thickly overlaid with custom and habit. Nevertheless, we may be quite sure that such differences exist. The German is not exactly the same kind of man as the Englishman, even if due allow- ance is made for acquired traits. Still less is the Japanese the same kind of man as the American. It is therefore safe to assume that in some of the manifold branches of industry the German will be superior to the Englishman, while in some he will be inferior. We may certainly as- sume that in some branches of industry the Japanese will be more successful than the American, while in other branches he will be less successful. INTERNATIONAL TRADE AND FOREIGN EXCHANGE 329 Cotton can be grown successfully by the native popula- tion of Central Africa. The tedious labor under a tropic sun is more easily borne by the native blacks than it would be by persons of European descent. The manufacture of cotton cloth by modern methods requires a higher degree of intelligence, perseverance, and responsibility than the native African population possesses. This branch of the industry may better be carried on in a country like Eng- land, where the population has the required traits in a high degree of development. Accordingly, there is a natural basis for permanent trade between England and Central Africa. Trade based upon such essential differ- ences in national character also tends to increase in im- portance with improvements in the means of transportation and communication. 6. International trade based upon differences in relative supply of land eventually loses a large part of its importance on account of the movements of population. Trade based upon differences in relative supply of land attained extraordinary proportions during the nineteenth century. The Old World, for the most part, was densely peopled ; in the New World population was sparse. It is a well-known fact that the largest output per workman of agricultural products is attained through the superficial cul- tivation of large areas. England may have lands that are naturally better adapted for the growing of wheat than the lands of Argentina. But it is hardly possible for one man cultivating twenty acres in England to produce as many bushels of wheat as one man cultivating two hundred acres in Argentina. In manufactures, on the other hand, density of popula- tion, instead of reducing productive efficiency, tends to in- crease it. Men who live in constant association are better fitted for the organized activity of the modern factory than are men who pass their lives in the isolation of the frontier. 330 INTRODUCTION TO ECONOMICS Hence an exchange of agricultural products for manufac- tures between the New World and the Old was in the nat- ural order of events. During the greater part of the nineteenth century trade between the United States and England was chiefly of the character just described. The United States possessed vast tracts of land for extensive cultivation ; England had a dense population well fitted for factory labor. Hence we exported foodstuffs and raw materials and imported manufactures. While trade upon this basis tends to increase with re- duction in costs of transportation, there is a counter tend- ency at work which in time checks it. Immigration flows into the regions rich in land; the natural increase of population in those regions is likely to be rapid. In the end such regions lose their peculiar advantages in the production of foodstuffs and raw materials, and gain in power to produce manufactures cheaply. Trade of the character under discussion may continue for centuries, but ultimately it decays. The United States still exports large quantities of foodstuffs and raw materials and imports manufactured goods. But these elements in our foreign trade no longer maintain their former supremacy. In an- other century the United States will doubtless import chiefly raw materials and foodstuffs from regions which remain sparsely peopled and export manufactures in exchange. 7. International trade based upon differences in relative supply of capital is of waning importance, since capital flows easily from country to country. We need not dwell at length upon the trade that is based upon differences in the supply and cheapness of capital. So long as England was par excellence the land of capital, and so long as English capitalists were unwilling to invest their funds in foreign lands, there were many INTERNATIONAL TRADE AND FOREIGN EXCHANGE 331 branches of manufacture that could be prosecuted with far greater advantage in England than in other countries. In practically every branch of manufacture, in fact, the interest on capital makes up a far larger proportion of the total expenses than in grazing, agriculture, lumbering, etc. It is easy to see, then, that English manufacturers, with interest at iive per cent, enjoyed a decided advantage over American manufacturers, with interest at eight per cent. The English farmers and stockmen, it is true, also had an advantage in interest rates over their American competitors. But the advantage was of less relative importance and more easily offset by other factors in which the Americans en- joyed an advantage, such as cheaper land. Under present-day conditions no country can long hold a branch of trade merely through cheapness of capital. Like labor, capital tends to migrate to the less developed regions of the world ; its migration involves far less per- sonal sacrifice and far less cost. Furthermore, capital in- creases rapidly in the newer lands. If interest rates were much higher in the United States than in Great Britain, British capital would steadily flow into the former country ; and this influx of capital, added to the new capital con- stantly accumulating here, would tend to depress interest rates, until there remained no perceptible difference in the rates prevailing in the two countries. The trade based upon differences in capital supply may, therefore, be re- garded as transitory. 8. International trade based upon differences in traditions of workmanship often manifests a high degree of perma- nence. In a region that has long been devoted chiefly to a given branch of industry, something that we may call a tradition of workmanship evolves., The best type of iron worker is not developed in a single generation. The mill that is manned with workers whose fathers and whose fathers' 332 INTRODUCTION TO ECONOMICS fathers were reared in a world of iron manipulation pos- sesses a decided, though indefinable, advantage over the mill that is manned with workers whose antecedents were of the field or forest. Costly experiments in settUng urban stock upon farms have demonstrated the soundness of the popular view that it takes generations to make a farmer. Still more important is the tradition of workmanship in in- dustries requiring a high degree of taste and skill. Where is the Occidental who can produce a true Oriental rug ? When other conditions are ripe, the population of any region may develop the tradition of workmanship neces- sary for the successful prosecution of any specific branch of industry. But no region can be expected to gain a su- periority in all lines. We may at some future time be able to make gowns as well as the French, and ivory toys as well as the Japanese. But there will always be objects of taste which we must buy from the French and the Japanese. Trade based upon such differences may, therefore, be treated as permanent in character. 9. The foreign trade of modern nations is based upon a combination of differences, some of a permanent and some of a transitory nature. In the foreign trade of a great country like the United States or Great Britain it is natural that we should find one part having one underlying basis, another part another basis. In many cases the exportation or importation of a commodity arises from a combination of several of the causes which we have described as bases of trade. The ex- portation of iron and steel products from Great Britain to India is based upon the fact that Great Britain has vastly superior deposits of iron ore and coal, cheaper capital, and a population better fitted than that of India for metallurgi- cal industry and possessing a superior tradition of work- manship. The exportation of wheat from the United States to England is based solely upon the greater abun- INTERNATIONAL TRADE AND FOREIGN EXCHANGE 333 dance of land, relatively to the population, in the former country. The importation into the United States of French articles of taste may be due in part to superiority of the French national character, in this respect; but it is un- doubtedly due in large part to a superior tradition of work- manship on the part of the French. With the lapse of time we shall cease to export many of the commodities we now export; many of the commodities which we now im- port will be produced in this country. 10. A country may import commodities for the production of which it is better fitted by nature than are the countries which export these commodities. Such a proceeding is economical when the first country enjoys even greater advan- tages in the production of other commodities than the other countries enjoy. We have, hitherto, considered only cases in which each one of two trading regions possesses unique, or at any rate superior, advantages in the production of the commodities which it exports. Under certain conditions trade may be advantageous even when this is not the case. To use a time-honored illustration, let us suppose that the United States, by reason of its natural wealth and the character of its population, is in a better position to produce both wheat and steel than England. A day's labor will produce more of either commodity in America than in England. Yet it may be profitable for the United States to buy its steel from England, giving wheat in exchange. We will assume that in America a day's labor will produce four bushels of wheat or two hundredweights of steel, while in England a day's labor will produce one bushel of wheat or one hun- dredweight of steel. Disregarding the costs of transporta- tion, it would be profitable for America to offer England three bushels of wheat in exchange for two hundredweights of steel, and it would be profitable for England to ac- cept the offer. America would thus obtain two hundred- 334 INTRODUCTION TO ECONOMICS weights of steel for three fourths of a day spent in wheat growing, instead of spending a whole day's labor in making the steel. England would obtain three bushels of wheat through two days' labor spent in steel making, instead of spending three days' labor producing the same amount of wheat. America possesses an advantage in either industry, but her advantage is greater in wheat growing. England is at a disadvantage in either branch of production, but her disadvantage is less in steel making. It is therefore natural, under the assumed conditions, that America should make a specialty of wheat production, England of steel making, and that the two countries should carry on a mutually profitable trade. This case is obviously analogous to the case of ex- change between shoemaker and woodcutter which we em- ployed in the early part of this chapter. But while any person of ordinary intelligence can see how it may be prof- itable for an efficient shoemaker to hire a man less fitted than himself for woodcutting to supply him with wood, it appears to be beyond the comprehension of most ordinary men, and many extraordinary ones, that a country can prof- itably pursue the same business policy. Since a day's labor does actually produce more steel in the United States than in England, many men believe that it must be unprofit- able for us to buy steel from England. Obviously, they fail to consider the possibility that we may have other in- dustries so much more productive than those of England that we cannot afford to divert our labor to the making of steel. 11. From the fact that a country has greater natural ad- vantages for the production of a commodity than other countries enjoy, it does not necessarily folloiv that the money cost of the commodity is lower in the former country than tn the others. Let us look at the matter from another point of view — that of prices and money cost of production. The men who INTERNATIONAL TRADE AND FOREIGN EXCHANGE 335 engage in the business of importing and exporting commodi- ties do not inquire into underlying bases of trade. Their inquiries begin and end with prices. Is steel cheaper in England than in America ? If so, and if the difference is great enough to pay the cost of transportation, they import the steel, unless they are prevented by government from doing so. Is wheat cheaper in America than in England.? If it is enough cheaper to pay the costs of transportation, they export it. But why should steel be cheaper in England than in America, while wheat is cheaper in the latter country ? Prices, we know, tend to equal money cost of production ; therefore we may assume that it costs less to produce steel in England, wheat in America. Our inquiries cannot stop here, however, for we must know why it costs more to pro- duce the one commodity in the one country, the other com- modity in the other country. Ask a steel manufacturer why it costs more to produce steel in this country than in England, and he will probably reply, " Labor is dearer." The pay of English steel workers is, indeed, lower than that of steel workers in America, but so also is the pay of English agricultural laborers lower than that of farm hands in America. It is, therefore, plain that it is not the low wages, absolutely considered, that give the British steel manufafcturer an advantage, but the low wages, relatively to the productive efficiency of the workmen. Low wages do not make British agriculture prosperous, be- cause the productive efficiency of laborers in that industry is low, relatively to wages. The disadvantage of the British steel industry as compared with the American is less than the disadvantage of British agriculture as compared with American. 12. It is profitable to import a commodity whenever labor and capital engaged in its production yield less than the same agents would yield in other fields. 336 INTRODUCTION TO ECONOMICS We shall get a clearer view of the situation if we stop to consider the principles determining cost of production. Wages and interest are the chief constituents of cost of pro- duction ; but we will fix our attention upon wages alone. In earlier chapters we saw that wages are determined by the marginal productivity of labor. Now, let us suppose that one trading region has a vast extent of fertile land and a sparse population. Only the best lands are tilled and these in a superficial way. Add a thousand laborers to the population. How much can they produce .? Perhaps five bushels per man a day. This amount of wheat, or the price of it, they can demand as wages ; all other equally eificient workmen will get as much, but no more. Another trading region has, let us say, a dense population and little land. All the good lands are carefully tilled ; most of the poor lands are also under cultivation. Add a thousand men to the working population. It is highly improbable that these men will increase the product by five bushels per man per day. Rather, we may assume that the daily product of a man is only one bushel. And this, or its price, is all that any equally efficient laborer in the society can get. If the two regions are in easy communication with each other, the price of wheat in the one will be the same as the price in the other, allowance made for the cost of shipping wheat from the one to the other — -a few cents per bushel, we will assume. This means that money wages will be much higher in the region which is sparsely settled than in the region where population is dense. Now, let us suppose that each region possesses ores and coal, but that the deposits of the sparsely settled region are so much the richer that a day's labor will produce from them twice as much steel as a day's labor will produce from the deposits of the densely settled region. Enterprisers of the former region will have to pay miners, furnacemen, etc., at least as much as they could earn in agriculture — the price INTERNATIONAL TRADE AND FOREIGN EXCHANGE 337 of five bushels a day. Enterprisers in- the region of dense population will also pay wages gauged by the returns to agricultural labor — the price of one bushel a day. A simple calculation will show that steel manufacturers in the region of dense population can produce steel much more cheaply than their competitors in the other region. In order to make our example correspond more closely with reality, we should need to substitute, for steel mak- ing only, a wide range of industries, mainly manufactur- ing ; for wheat raising we should substitute a wide range of industries, mainly extractive. We might then say, with perfect truth, that in a sparsely settled region the margi- nal productivity, and consequently the wages of labor, are likely to be so high that manufactures cannot be carried on profitably in competition with a densely settled region, where the marginal productivity of labor, and hence wages, are low. American manufacturers of iron and steel prod- ucts have for a century been forced to pay higher wages than English manufacturers, largely because the produc- tivity of labor in agriculture was so much higher here than in England. 13. Trade between different countries is essentially barter. In early times, interregional trade, like all other forms of trade, was carried on through barter. The Phoenician merchant, we may safely assume, carried to each port commodities that he thought would be in demand there, and bartered them for commodities which he desired. In a later stage money was employed, but chiefly for effect- ing exchanges within a single locality. The artisan mer- chants of the mediaeval Hanse towns trading with England carried cloth and other wares to London and exchanged them for wool and other English products. Doubtless when in England the Hanse merchants often first ex- changed their wares for local currency, and exchanged the currency in turn for goods to carry back to Germany. 338 INTRODUCTION TO ECONOMICS From the point of view of the two trading regions, the trade was an exchange of goods for goods, or barter, in spite of the employment of currency in England. In a later stage the importation of goods is partly di- vorced from the exportation of goods. Men having goods that they believe will fetch a high price in a foreign mar- ket ship them abroad, expecting to receive the price of the goods in the form of gold and silver. Men wishing to buy foreign goods send gold and silver in payment for them. Hence, exportation and importation of the precious metals may be often carried on concurrently, at a consider- able risk and expense. Here obviously is opportunity for the development of a system of set-offs, to reduce the transmission of the precious metals between the two trad- ing regions to a mere settlement of balances. By this system, which long ago reached a high degree of develop- ment, international trade is reduced practically to barter — exchange of commodities for commodities. 14. The use of gold in international payments is largely obviated by the employment of bills of exchange. Let us suppose that A, a New York exporter, has sold 10,000 bushels of wheat to X, a Liverpool importer, at the price of ;SSi a bushel. If he wishes the ^10,000 deliv- ered to him at New York, in gold, he must, of course, pay freight and insurance on it. This will cost about $l for every $500, or %6o for the entire sum. But suppose that after shipping the wheat, and before giving orders for the delivery of the gold, he meets B, a New York importer, who is about to order $10,000 worth of woolen goods from Y, a Liverpool exporter. If B were to ship the $10,000 in gold to Liverpool, it would cost him $60 for freight and insurance. Now, if A will give B an order instructing X to pay Y the $10,000, instead of re- mitting it to himself, B can pay A the $10,000 that he would otherwise have remitted to Y. Both debts will be INTERNATIONAL TRADE AND FOREIGN EXCHANGE 339 extinguished by such an arrangement, and both A and B can save ;^6o by it. Such an order as we have assumed that A gives to B, re- questing X to pay Y a certain sum originally due to A, is known as a bill of exchange. Such a bill may be payable as soon as it is presented to the person upon whom it is drawn, or it may be payable after the expiration of a period of time — twenty, thirty, sixty days. In the for- mer case it is a " sight bill," in the latter a " time bill." Time bills usually bear interest — a fact that assimilates them to other credit instruments, but has no bearing on the principles of exchange. We shall therefore assume that bills of exchange are sight bills only. In our example it appeared that both A and B gained $60 by the arrangement. Now, if B had been unwilling, for some reason, to give A ;^ 10,000 for the latter' s bill of exchange, A might have taken less! It would have been more profitable for him to take 1^9950 than to incur the expense of importing the gold. If B had offered 1^9940, it would have been a matter of indifference to A whether he sold his bill to B or imported the gold. ^9940 is evi- dently the very lowest price at which the bill would be sold. On the other hand, if A had been unwilling to part with his bill for just ;^io,ooo, B might have offered more, for he could better have afforded to pay ^10,050 for the bill than stand the expense of exporting gold. If A had demanded ^10,060, it would have been a matter of indifference to B whether he bought the bill or shipped the gold. ^10,060 is, then, the very highest price that a ^10,000 bill can be made to fetch. 15. Bills of exchange sell at par when the supply of them just equals the demand. When the supply is less than the demand, they rise above par ; when the supply exceeds the demand, they fall below par. When a bill of exchange sells for just its face value, it is 340 INTRODUCTION TO ECONOMICS said to be at par ; when for more or less, it is above or below par. We have now to inquire under what conditions bills will be at par, or above or below par. If the importer whom we designated as B thinks that the chances are good that he can find other exporters be- sides A who are anxious to dispose of bills of exchange, he is likely to offer less than par for A's bill. If one of the holders of bills will not sell at a low price, another probably will. If, on the other hand, A thinks that he can easily find other persons besides B who have payments to make abroad, and who are anxious to purchase bills for the pur- pose, he is likely to hold his bill at a price above par. In general terms, when the volume of bills offered for sale appears to exceed the volume of remittances to be made to a foreign center, bills fall below par. When the volume of bills appears to be inferior to the volume of remittances to be made, bills rise above par. In the former case, each holder of a bill knows that some bills cannot be sold at all ; their holders will have to go to the expense of import- ing specie. Rather than be left in this position himself, he is wilhng to sell his bill at less than its par value, provided that the price offered is not so low that to bear the cost of import- ing specie would be a lesser evil. In the latter case each person having remittances to make knows that some men will have to go to the expense of exporting specie. Hence each one will offer more than its par value for a bill of exchange. 16. When all the payments that one trading region must Tnake to another equal the payments to be m.ade by the latter region to the former, the supply of bills equals the demand, and exchange is at par. We must now endeavor to determine the conditions un- der which the volume of bills equals, is superior to, or in- ferior to, the volume of remittances. We shall assume that the relations between the United States and Great INTERNATIONAL TRADE AND FOREIGN EXCHANGE 341 Britain are carried on without regard to relations with other countries, and that American business is all handled through New York, British through London. The United States, we will assume, exports in one year products worth 1^500,000,000 to Great Britain, and Great Britain exports products worth ;^2 50,000,000 to the United States. Under the head of exports and imports, we shall have bills on London aggregating ;^ 5 00, 000, 000, and remit- tances to make aggregating only ^250,000,000. Citizens of the United States still owe vast sums to citi- zens of Great Britain ; citizens of Great Britain owe lesser sums to citizens of the United States. Interest on these debts will be transmitted by way of exchange. Let us say that Great Britain must pay us $5,000,000, while we must pay Great Britain $75,000,000. This will add $5,000,000 to the total volume of bills, and $75,000,000 to the aggre- gate of remittances. Some American borrowers are paying off their debts to British capitalists ; others are borrowing fresh capital. The sum of payments at present probably greatly exceeds the sum of new loans. We will put the former at $130,000,000, the latter at $25,000,000. Under this head, then, we may add $25,000,000 to the volume of bills, $130,000,000 to the volume of remittances. Americans living or traveling in England must have their incomes sent them from here; Englishmen living or traveling here must have their incomes sent from England. Let us suppose that we must send $ 1 5,000,000 to our citizens in England; England must send $5,000,000 to her citizens here. This would add another $5,000,000 to the volume of bills, $15,000,000 to the volume of remittances. Most of our trade with Great Britain is carried on by British ships. We must, of course, pay for the service, and our payments must be sent to Great Britain. We will place the aggregate at $75,000,000, What we carry for Great 342 INTRODUCTION TO ECONOMICS Britain is too little to take into account. So we must add ;^7S, 000,000 to the volume of remittances without any off- setting increase in the volume of bills. DUE THE UNITED STATES DUE GREAT BRITAIN Exports $500,000,000 $250,000,000 Interest 5,000,000 75,000,000 Proceeds of new Repayment of old loans 25,000,000 loans 130,000,000 British travelers' ex- American travelers' penses 5,000,000 expenses 15,000,000 Payment for ocean transportation 75,000,000 $535,000,000 $535,000,000 Footing up the assumed items of indebtedness, we find that the United States can draw bills to the amount of $535,000,000, and must make remittances to the amount of i^S 3 5. 000,000. Exchange on London will be at par under these conditions. Of course, it is rarely the case that the payments to be made between two countries exactly balance. At one time the balance is in favor of one country, at another time in favor of the other. When our claims upon Great Britain exceed the claims of Great Britain upon us, bills drawn on London are below par. When we owe Great Britain more than is due us from Great Britain, London exchange is above par. 17. The price of exchange on London depends upon the balance of indebtedness between the United States and all foreign countries, not upon the balance of indebtedness between the United States and Great. Britain alone. For simplicity we assumed that the exchange relations between the United States and England were not compli- cated by relations with other countries. This assumption we must now abandon. The United States buys coffee from Brazil. Brazil buys manufactures from England. INTERNATIONAL TRADE AND FOREIGN EXCHANGE 343 England buys wheat from the United States. Now, it is evi- dent that Brazilian coffee exporters will be glad to accept from American importers bills of exchange drawn on Lon- don, as these bills will be in demand among Brazilian im- porters of British manufactures. If the sums that Americans must remit directly to England aggregate ^300,000,000, and the sums that Eng- land must pay directly to the United States aggregate ;^32S,ooo,ooo, bills drawn on London may yet be above par. For American coffee importers may need, say, 1^40,000,000 in bills on London to make payments in Brazil. In this case, the remainder of the volume of bills will not be suffi- cient to meet the demand for them, and they will go above par. Even if the Brazilians imported nothing from England, bills drawn on London would nevertheless be acceptable to them as means of payment for their exports. Brazil must import from some country, and that country, in all probabil- ity, has payments to make in England, and so will accept bills on London in preference to gold. This follows from the fact that England has for a century been the financial and commercial center of the world. The whole world deals with England. Hence bills of exchange drawn on London have become a favorite medium of international payments throughout the world. If you wish to remit money to a missionary in China or to a stockman in Patagonia, you will probably do it through exchange on London. Similarly, if Chinese or Patagonians have remittances to make to you, they will employ exchange on London for the purpose. Accordingly, the demand for bills on London is prac- tically equal to the whole volume of payments to be made by Americans to persons living outside of the United States; the supply of bills amounts practically to the aggregate payments to be made by such persons to Ameri- cans. When we must pay foreigners exactly as much as 344 INTRODUCTION TO ECONOMICS they must pay us, exchange on London is about at par. When the balance of payments is in our favor, exchange is below par ; when the balance is against us, it is above par. Naturally, exchange on London is expressed in terms of the British currency — pounds sterling. When ex- change is at par, the pound sterling is quoted at $4.86^. When exchange is above par, an American who wishes to remit a pound sterling to England must pay more than $4.86^ for it — perhaps $4.88. If the price of a pound sterling (exchange) rises above ^4.89!, it pays better to ship gold. The point at which all advantage in employing bills of exchange instead of gold ceases, is known as the gold point. If the price of the pound sterling declines to ^4.831, it pays holders of bills to send them over to Eng- land for collection, with orders that the gold be shipped to America. $4.83! is therefore also known as a gold point. 18. If other items of international payments remain un- changed, the pi ice of bills of excharige is lowered by an in- crease in exports or a decrease in imports ; it is raised by a decrease in exports or an increase in imports. If we assume that other items of international payments (transmission of capital, interest payments, travelers' ex- penses, payments for ocean transportation) remain con- stant, it follows that fluctuations in exchange follow fluctuations in exports and imports. If we increase our exports, imports remaining unchanged, the supply of bills increases, and their price tends to fall. If we increase our imports, exports remaining the same, the volume of remit- tances to be made increases, and exchange rises in price. 19. Fluctuations in the rate of exchange tend to bring about a balance of international payments, through stimulat- ing exports and discouraging imports, when exchange is above par, and through discouraging exports and stimulating im- ports when exchange is below par. When bills are above par, it is more than usually prof- INTERNATIONAL TBLADE AND FOREIGN EXCHANGE 345 itable to export goods. Let us suppose that in New York the price of wheat is ninety-four cents a bushel, while in England the price is ;^i. If it costs five cents a bushel to ship wheat from New York to England, the exporter will make ^100 on a 10,000 bushel shipment, if exchange is at par. If exchange is at its maximum above par, the exporter will be able to sell his ;^ 10,000 bill for $10,060, thus adding ;jS6o to his nominal profit of $100. If exchange is at its minimum below par, the exporter can get only ;^9940 for his ;? 10,000 bill, thus losing $60 of his nominal profit of ;^ioo. If a profit of i^ioo on 10,000 bushels is just suffi- cient to induce exporters to ship wheat, no wheat will be shipped if exchange is below par. When exchange is below par, it is more than usually profitable to import goods. Let us suppose that it barely pays to import a certain kind of woolen goods when ex- change is at par ; that under these conditions the importer makes only ;^ioo on a ;^io,ooo shipment. If exchange is at its lowest price, the importer can pay for his goods with a $10,000 bill costing only $9940. Thus he adds $60 to his profits. If exchange is at its highest price, and the im- porter must pay $10,060 for a $10,000 bill, $60 is deducted from his profit, and the business ceases to be worth while. It follows that there is a tendency for an excess of either exports or of imports to check itself. If our exports in- crease, other things equal, exchange falls, and this dis- courages further exports, but encourages imports. If our imports increase too rapidly, exchange rises, and this dis- courages further imports and encourages exports. The fluctuations of the rate of exchange, then, have a tendency to create a balance of exports and imports — al- lowance made for other items of international indebtedness. Exports and imports, in the long run, must increase or de- cline together. 20. If the difference in the general price level between 346 INTRODUCTION TO ECONOMICS two countries is so great that fluctuations in the price of bills of exchange cannot bring about a balance of payments, gold flows from the one country to the other until the price level becomes practically the same for both. But suppose that the margin between prices in two coun- tries is so wide that it pays to export in spite of a low price for exchange, or to import in spite of a high price. In the former case, gold must be imported to pay for the exports ; in the latter, gold must be exported to pay for the imports. Now, we saw in an earlier chapter that an in- crease in the supply of money tends to raise prices; a reduction of the money supply causes prices to fall. If, then, our prices are so low that men find it profitable to send an excess of commodities abroad for sale, to be paid for in gold, the condition must be transitory. For as the gold flows into the country, prices rise, and the exporters' gains grow smaller and smaller. If, on the other hand, general prices here are so high that it pays importers to bring into the country vast amounts of goods, to be paid for by exportation of gold, the condition must be equally transitory. With the efflux of gold, prices fall, and the profits of importers dwindle away. In the end more of our commodities become cheap enough to export; and so the balance between exports and imports is re- stored. There are men who hold that the United States should endeavor to increase its exports, but systematically dis- courage importation. It is obvious that such a policy would be futile. If our exports increase, our imports will neces- sarily increase also, and vice versa. The fluctuations in the price of foreign exchange, and the effects of influx or efflux of gold, insure this result. Exports and imports are indis- solubly united by natural law; governments can destroy both, but no policy can be successful which aims to foster the one while persecuting the other. INTERNATIONAL TRADE AND FOREIGN EXCHANGE 347 21. Summary. Trade, both domestic and international, is based upon differences in productive powers. The trade between two nations may arise frpm the fact that each possesses exclu- sive powers of producing certain commodities; or it may- arise from the fact that each is superior to the other in some particular branch of production. The differences in productive powers upon which international trade is based may be due to differences in the character of population, differences in traditions of workmanship, differences in natural endowment, or differences in supply of capital. Of these differences some tend to disappear with lapse of time, while others constantly increase in importance. A country may profitably import commodities for the production of which it possesses natural advantages supe- rior to those of the exporting country. This is often the case when the marginal productivity of labor and capital, and hence money cost of production, is higher in the former country than in the latter. The trade between two countries is carried on through the mechanism of exchange. Gold payments are reduced to a mere settlement of balances; hence it may be said that international trade is essentially barter. When exports exceed imports, other things equal, ex- change falls below par; and this tends to encourage importation and discourage exportation. When imports exceed exports, exchange rises above par ; and this tends to encourage exportation and discourage importation. Thus fluctuations in the rate of exchange tend to bring about an even balance of exports and imports. If for any reason the balance of trade inclines persistently in one direction or the other, gold is imported or exported, and this, through affecting prices both domestic and foreign, ultimately establishes an even balance of international exchange. CHAPTER XIX THE REGULATION OF FOREIGN TRADE 1. Foreign trade is subjected to governmental regulation chiefly under the form of taxation. Since early modern times a great part of the energy of governments has been expended upon the regulation of international trade. The reason for such regulation has been twofold. In the first place, there is a deep-rooted belief in the people of every nation that the national pros- perity may be furthered by restrictions upon trade with foreigners. In the second place, such trade has long been recognized as a convenient and appropriate source of public revenue. A century ago the policy of prohibiting the importation of some classes of goods, and the exportation of other classes, was widely followed. At present this policy has practically fallen into disuse. Some of the states of east- ern Europe prohibit the exportation of grain when the supply appears to be insufficient to keep the people of those states from starving. Most countries prohibit the importation of certain commodities that are believed to menace the health of the consumer. Omitting such ex- ceptional cases, however, we may say that the regulation of foreign trade is everywhere carried on under the guise of taxation. If we wish to prohibit the importation of cot- ton from Egypt, we place such high taxes upon imports of Egyptian cotton that no one finds it worth while to import it. Taxes on foreign trade may be levied upon either im- ports or exports or upon both. Export taxes are generally unpopular, because of the common belief that it is a good 348 THE REGULATION OF FOREIGN TRADE 349 thing to export as many goods as possible. In the United States export taxes are prohibited by the Constitution. We shall therefore confine our study to taxes on imports. 2. Import taxes, or "duties" may be levied for the sole purpose of raising a revenue, or for the purpose of discour- aging the importation of commodities of classes that can be produced within a country. Taxes levied for the former purpose are called revenue duties ; taxes levied for the latter purpose are called protective duties. Before the annexation of Porto Rico all the coffee used in the United States came from foreign soil. A tax (or " duty ") of, say, five cents a pound under the conditions would have discouraged importation in only a slight de- gree. Most of us would have used as much coffee, even at the higher price. A duty of $20 a ton on steel, on the other hand, would practically prohibit the importation of steel. For our own steel industry can produce steel almost, if not quite, as cheaply as that of any foreign country. Suppose that we can produce steel at $15 a ton while in some foreign country it can be produced at $12. If the cost of bringing steel from the foreign country is $2 a ton, foreign producers can sell steel here at lower prices than our own producers can afford to take. But if foreign steel is compelled to pay a duty of ;^20 a ton, none of it can be sold here, unless the American producers combine and force steel up to the price of $34 a ton. Such a duty, since it "protects" domestic producers against foreign competition, is known as a protective duty. All duties levied upon imported goods of a character that cannot be produced in a country may be classed to- gether as pure revenue duties. All duties levied on goods of a character that can be produced in a country are pro- tective duties. Of course a duty the aim of which is the raising of revenue may be incidentally protective. Thus if we were to levy a duty on imported coffee, it would 3SO INTRODUCTION TO ECONOMICS " protect " the coffee growers of Porto Rico. On the other hand, protective duties may incidentally yield a rev- enue. In the case employed above, if the duty on foreign steel had been ^i instead of $20, foreign steel would have continued to be imported, and thus a revenue would have been obtained. At the same time the foreigner would have been prevented from underselling the Ameri- can ; accordingly, the latter would have been " protected." Most of our duties are protective, but incidentally yield a revenue, as they are not high enough to prevent importa- tion altogether. The schedule of all duties levied by a country is known as the " tariff." A tariff consisting of duties whose main object is the raising of a revenue is known as a revenue tariff. Such a tariff has long been in force in England. A protective tariff consists mainly of duties whose purpose is the protection of domestic producers against foreign com- petition. Such a tariff has been in force in the United States since early in the nineteenth century ; its character has been most strongly marked since the Civil War. 3. Revenue duties on imports are among the most conven- ient and popular forms of taxation, partly because the tax- payer does not realize how heavy the taxes are, and partly because of the common belief that such taxes are borne by the foreigners who export the goods. Every government needs large funds for the mainte- nance of the numerous corps of officials and servants making up its civil and military establishments and for the meeting of other expenses incurred in the discharge of its various functions. These funds must be obtained chiefly through taxation. Two methods of raising taxes are open to the government. It may send its officials to each man's house, and levy upon his person or property. In this case it is said to levy direct taxes. The government may, on the other hand, impose taxes upon salable commodities as they THE REGULATION OF FOREIGN TRADE 351 are found in the hands of producers or dealers. The latter then add the tax, in whole or in great part, to the selling price of the commodities taxed. The buyer of the com- modities thus bears ultimately all or the greater part of the tax. Such taxes are said to be indirect. For such obvious and imperative needs of government as the construction of highways, the maintenance of courts and schools, the average citizen is willing to pay direct taxes, although he usually quarrels with the amount imposed upon him. The benefits to be derived from a standing army or a navy are more remote, and the taxpayer would be far less willing to contribute directly to their support than to the support of local government institutions. For this reason, national governments rely largely upon indirect taxes. The average citizen has no very clear idea as to the amount of taxes he pays in this way. Whenever you buy a pound of imported sugar (and most of our sugar is imported) you pay a tax. Whenever you buy English woolens or cottons or French silks, you are taxed. If you use tobacco in kny form, or spirituous malt, or vinous liquors, you pay taxes on them. And so with a host of other commodities. How great is the aggregate yearly sum that you contribute to government in indirect taxes ? You probably have not the least idea. But this is certain ; if the entire amount were collected from you in cash at one time, you would feel that this government of ours is an expensive luxury. Statesmen would find much greater difficulty in convinc- ing you that we should have the greatest navy afloat, or that we should hold ourselves in readiness to enter upon a ^2,ocx),ooo,ooo war over a $200 matter. Of all indirect taxes, those levied on foreign trade are the most convenient. All foreign goods must cross the national frontier, where there are always officials and soldiers whose services can be employed in preventing goods from being secretly carried into the country. A few points through 352 INTRODUCTION TO ECONOMICS which such goods must pass may be designated ; a compara- tively small body of officials may be stationed at these points to levy and collect the taxes. Another reason for the popularity of taxes on imports is that many persons believe that such taxes are borne by foreigners. If we tax British woolens, French silks, and German sugar, are we not compelling the British, French, and Germans to help pay the expenses of conducting our government .■■ 4. Import duties are, as a rule, borne by the consumer, not by the importer nor by the producer. Let us say that a given grade of woolen goods is pro- duced in England at a cost of fifty cents a yard. Under the laws of competitive industry, the cloth sells in England for very nearly fifty cents. If the cost of bringing it to this country is one cent a yard, and there is no tax to pay on imports, the cloth will sell here for about fifty-one cents. Now if we place a duty of fifty cents a yard on the cloth, none of it will be sold here for less than the British price plus the cost of transportation plus the tax, or a dollar and one cent. The man who buys the goods for use pays the tax, in the last instance. And so with most import duties. There are exceptional cases in which the whole amount of the duty cannot be added to the original price of imported goods. In these cases the foreign producer may be said to bear part of the tax. As a general rule, however, the consumer of the goods pays the tax, although he may not be conscious of the fact. 5. Protective duties are sometimes advocated as a means of keeping m,oney at home. A revenue tariff needs no defense. A state must have revenues, and there is no easier way of collecting them than through import duties on commodities that we cannot our- selves produce. A protective tariff, on the other hand, re- quires more extended consideration. It is designed to foster THE REGULATION OF FOREIGN TRADE 353 domestic industry at the expense of the business of impor- tation. Whether it does this or not is a question of great importance. We must see exactly how such a tariff affects, not merely isolated branches of industry, but the industry of a nation as a whole. There is a very primitive view, unfortunately yet far from extinction, that it is an evil thing to buy anything from foreign producers — even the things that cannot be pro- duced in the country at all. Those who hold to this view imagine that we must send abroad money to pay for all pur- chases, and money, they say, should be kept at home. We saw in the last chapter that the medium through which in- ternational payments are effected is, in a vast majority of cases, bills of exchange. The shipping of gold from country to country is reduced, by the mechanism of exchange, to very small proportions. Now, the bills of exchange with which we pay for our imports are really due bills, representing the value of commodities that we export. We saw also that if a country for a time imports more than its exports will pay for, bills on foreign points rise in price, and this dis- courages further importation and encourages further expor- tation, until the proper balance between imports and exports is again restored. Accordingly, we may cheerfully proceed to import as large a volume of commodities as we may desire. We shall not thereby run the risk of a serious drain upon our money supply ; we shall merely make preparations for an unusually large and profitable export trade in the near future. 6. There is no sound reason for discouraging importation from countries which do not take commodities in exchange. Some men who have advanced beyond the view that all importation of commodities is an evil yet cling to the belief that importation from countries that do not buy as much from us as we buy from them is to be discouraged. They argue that such trade must leave a balance which we 354 INTRODUCTION TO ECONOMICS must pay in gold, and this they regard as a net loss. Not many years ago one of the administrative departments of our national government published a report containing the statement that our losses from trade with South America, during the last half century, exceeded the cost of the Civil War. For we had purchased from those countries billions of dollars' worth of commodities in excess of their purchases from us. Of course, the facts in the case are, not that we have sent billions of dollars in gold to South America, but that we have paid the balance in bills on England. Eng- land buys more from us than she sells to us, and in her turn, sells more to South America than she buys from that region. If ever our import trade with South America assumes ab- normally large proportions, our export trade with England expands in sympathy. It makes not the slightest difference whether our foreign trade is three-cornered, as in this case, or whether it is carried on directly with one other country. 7. The argument that the national wealtli is necessarily reduced when one purchases from abroad commodities that can be made at home is fallacious. Slightly less shallow is the view that one should not buy from foreigners commodities that he can obtain from his fellow-citizens, even if the latter demand higher prices than foreigners are content to receive. If you wish to buy an automobile, it is urged, you should buy one of American make, even if you can get as good one of French make a little cheaper. By so doing you will increase the prosperity of the American automobile industry. You will enable the industry to employ more men at higher wages, and to pay higher dividends to those who have invested their capital in the industry. In order that you and the rest of your class may be sure to lend your aid to the American industry, the government should place a tax on French automobiles imported into the country, which, added to the original price, would make them sell at higher prices than those made in THE REGULATION OF FOREIGN TRADE 355 this country. If you then persisted in encouraging French industry instead of that of your own country you would have to pay dearly for the privilege. The ulterior effects of a policy that compels American buyers to patronize the home industry are no less happy (so runs the familiar argument). The laborers and capitalists, being more prosperous, have more to spend on products for their own use. The capitalists erect mansions and the laborers build cottages, and this creates employment for car- penters, masons, and other craftsmen in allied trades. These in turn have more money to spend, and increase their pur- chases of clothes, provisions, and other articles of use. And so the beneficent effects of confining one's purchases of auto- mobiles to the American industry are widely distributed throughout society. In a similar way it is urged that we should buy all our sugar from our own producers. There is not much doubt that in ten years we could extend our production of sugar sufficiently to cover the demand for it, if we would but pay a sufficiently high price to tempt labor and capital into the industry. Instead of sending $100,000,000 abroad to fruc- tify foreign industry, we could keep it at home among our own workingmen and capitalists. Let us see whether the foregoing argument will bear close examination. Assuming that we import $100,000,000 of sugar in a year, how do we pay for it .■■ Not with gold, but with bills of exchange representing the value of com- modities that we export. Now suppose that we place so high a duty on sugar that importation ceases altogether. The immediate effect would be a reduction^in the demand for foreign bills aggre- gating $100,000,000 per annum. Bills would, of course, fail below par; men exporting wheat and meat and cotton- would get less for their products in consequence. The im- portation of commodities other than sugar would be stimu- 356 INTRODUCTION TO ECONOMICS lated, as we have seen, by the low price of bills. Exports and imports would have to be brought to a balancTe again, and this would come to pass through a shrinkage of exports and an increase of imports other than sugar. Perhaps we should buy annually ^50,000,000 more of these other im- ports than we did before, and export 1^50,000,000 less of wheat, meat, and cotton than we formerly exported. The producers of sugar are indeed benefited by the elimination of foreign competition, but the producers of wheat, cotton, etc., are injured by the reduced prices of exports, and the producers of other commodities, part of the supply of which is imported, are injured by the increase in importation of those commodities. Obviously enough, the evil ulterior effects of the losses of these two classes of producers cancel the beneficent ulterior effects of the gains of the sugar pro- ducers. The one effect of the duty that stands out with- out any corresponding offset is that we shall. pay ten cents a pound for sugar instead of five — certainly a result that no one can ardently desire. 8. Protection of all industries is an impossibility. But suppose that the government places prohibitive duties on all imports. Will not this place all industries in a position where they may enjoy higher prices .' And in that case, will it not be as easy for us all to pay ten cents a pound for sugar as it now is to pay five } A pro- tective system, it is often said, is unjust when it singles out a few industries and grants them special favors. But it is just if it favors all industries equally. An obvious objection is that if this were possible, if each industry were enabled to charge prices one hundred per cent higher, and each person, accordingly, received twice as large an income as he would otherwise have re- •ceived, no one would secure any real benefit at all. If the income of each of us should be doubled, and we had to pay twice as much for everything that we buy, we should THE REGULATION OF FOREIGN TRADE 357 be no better off than we are now. But a more serious objection is this : no protective policy can raise the prices of all commodities. A duty can raise the prices only of articles that we are in the habit of importing. Now, if we import anything, we must export something to pay for it, and the export commodities must ordinarily represent as great a volume of values as the import commodities. In the case of the United States, the volume of export com- modities must be greater than that of import commodities, for the former must pay interest on capital that we have borrowed and the cost of transporting our trade in foreign ships. Now, the price of a commodity that we export must be lower in this country than in the countries to which it is sent. The prices of wheat and cotton in America must be less than the prices of the same articles in England, since we are constantly exporting them. It is manifestly absurd to suppose that by placing duties on wheat and cotton im- ported into the United States we can raise the price of those commodities. Who would wish to import them into the United States .■• The duty on any export product is utterly ineffective. We have seen that restrictions on imports restrict ex- ports also. They do this by reducing the amount of money that the producer for export receives for his goods. An "all around" system of duties, in spite of itself, im- poses a positive burden on as large a volume of industry as that which enjoys special favors under it. 9. A plausible but fallacious argument for protection is that high wages in America cannot be maintained in free competition with low-wage countries. Another argument for protective duties runs as follows : The American laborer requires a greater measure of the necessaries and comforts of hfe than the laborers of any other country. His wages must therefore be higher. It 358 INTRODUCTION TO ECONOMICS follows that American enterprisers, having higher wages to pay, are at a disadvantage as compared with their for- eign competitors. They must therefore sell their goods at higher prices ; and this they would be unable to do if the foreign producer could bring his goods here without pay- ment of duty. From this point of view the tariff is re- garded as the bulwark of the American standard of living. This argument can no more bear analysis than the pre- ceding ones. All the export industries are able to pay the American scale of wages, and yet undersell their foreign competitors on foreign soil. These industries are ham- pered, not aided, by the protective system. Apart from the injury inflicted upon them by an unfavorable rate of exchange, these industries are rendered less profitable by the fact that many of their expenses are increased by the tariff. Wheat and cotton growers are compelled to pay higher prices for agricultural implements, lumber, fertil- izers, and other supplies because of the protective duties. The duties on iron and steel increase the costs of railway building and are reflected in higher freight rates, which represent a deduction from the net gains of the producers of the commodities that are carried to the ports by rail. If restrictions on imports reduce the amount of freight carried to this country from Europe, many ships are com- pelled to cross the ocean in ballast to carry away our exports ; and this means that the exports have to pay ocean freights covering the costs of a return voyage, in- stead of a single passage of the ocean. Now, when we consider that in spite of all these disadvantages the export industries can retain the home market and invade foreign ones, we see clearly that a protective tariff is not needed to maintain the American rate of pay in all industry, although it may be necessary to maintain that rate in special industries — industries in which our advantages for production are less telling than they are in those in- THE REGULATION OF FOREIGN TRADE 359 dustries that have succeeded in conquering a place for themselves in foreign markets. 10. A policy which draws labor from the fields that are of greater natural productiveness to fields of lower natural productiveness tends to reduce wages. In order to gain a clear view of the relation of a protec- tive duty to the rate of wages we must return to funda- mental principles. In any country, as was shown in earlier chapters, wages are determined by the marginal produc- tivity of labor. We will represent the various opportuni- ties for employment that a country like the United States affords by the symbols A, B, C, and D. A may stand for a group of industries in which we have exceptional advan- tages over foreign countries. B stands for a group of in- dustries in which our advantages are less, C one in which they are still less, and D the group of industries in which they are least of all. When our population is so small that all our labor can be engaged in the group represented by A, wages will be at their maximum. When our population increases so that some of the labor will have to be set at work in group B, the wages of all labor must decline to the level of productivity in that group. We will suppose that population has increased up to a point where the op- portunities represented by A and B are fairly well manneci, and wages are determined by the productivity of labor in B. With wages thus determined, it is clear that no employer, without governmental aid, can afford to hire labor to ex- ploit the opportunities represented by C and D. This would necessitate paying labor in C and D as much as it produces in B, and that, by hypothesis, is more than it produces in C and D. Now let us suppose that a political party is in power which holds the beUef that we should produce everything that we consume — that is, that the opportunities repre- sented by C and D should be exploited as well as those rep- 360 INTRODUCTION TO ECONOMICS resented by A and B. Labor must be drawn away from A and B and set at work in C and D. This involves the necessity of compensating enterprisers in some way for the disadvantages under which they will operate in C and D. Either wages must be reduced in A and B, or some form of subsidy must be granted to C and D. The commodities that the industries composing C and D will produce have been hitherto, we assume, obtained from abroad through exchange for commodities produced by A and B. The government now renders this difficult by placing high duties on the former class of commodities. This means that producers in the groups A and B — both employers and workmen — must pay higher prices for what they buy. They do not receive higher prices for what they sell ; in fact, they receive lower prices, as this, we have seen, is the effect of protective duties on export industries. It appears, then, thai part of the disadvantage of producers in C and D is removed by reducing wages (estimated in purchasing power) in A and B. After the duty has gone into effect and the prices of commodities that can be produced by C and D have risen sufficiently, enterprisers will be able to hire labor at the wages prevailing in A and B, and establish industries in C and D. So far as the remaining laborers in A and B buy the products of C and D, the difference between the price which they pay for those products and the price that they would pay if they were permitted to import those products duty-free is a tax paid not to the government, but to the producers in C and D, to enable the latter to remain in busi- ness. It is an uncompensated deduction from the natural earnings of the laborers in A and B. Their wages have been reduced; nor are the workers in C and D paid as much, estimated in purchasing power, as they would have received if they had been allowed to remain in A and B under the earlier conditions. The net effect of the impo- THE REGULATION OF FOREIGN TRADE 361 sition of the duty has been to saddle the self-supporting industries, A and B, with the support of the pauper indus- tries, C and D. Yet the inventors of this poUcy have the effrontery to tell laborers in A and B that this policy is the bulwark of their high rate of wages ! The principles involved in the illustration may be stated in the following general terms : Wages in any country will be at the highest point when all the labor of that country is concentrated in the industries in which its relative ad- vantages over other countries are greatest. If there are no protective duties whatsoever, employers will, as a rule, seek out the industries in which their country has the greatest relative advantages. Protective duties enable other industries to exist, but only through taxing the more productive industries for their support. Protection as a permanent policy means a slight reduction of money wages, and a greater reduction of wages estimated in pur- chasing power. Instead of a bulwark of the standard of living, protection is a serious menace to it. 11. The strength of the protectionist policy consists largely in the fact that the good effects of the policy are more easily perceived than the evil effects. The arguments for protection that have been discussed are all manifestly fallacious. They are not therefore to be despised, since to hosts of men they appear to be absolutely irrefutable. And this, as a great French economist was wont to say, is because the average man is unable to weigh the unseen effects of an economic policy against the effects that are seen. If we place a high duty on imported fab- rics, the resultant high prices enable a new industry, em- ploying thousands of workmen, to be established. This is the effect that is seen, and considered in itself, is wholly good. Every purchaser of the fabrics throughout the land is compelled to pay higher prices for them ; but this effect is only dimly seen, if at all. In itself, it is wholly evil. 362 INTRODUCTION TO ECONOMICS Since part of what the new industry receives in this way from the public goes to compensate that industry for the natural disadvantages under which it labors, it follows that the aggregate net gain to the industry is less than the ag- gregate net loss to the public. Again, the national pro- duction of wealth is increased by the amount that the new industry adds, and this effect of the duty is one that is seen. The national production is reduced by the amount that the labor and capital diverted to the new industry would have produced elsewhere ; this effect is not seen. Yet the re- duction in national production that the duty entails is greater than the increase due to it, since labor and capital are diverted from the branches of production enjoying greater natural advantages to branches enjoying lesser advantages — a fact proved by the very need for a duty. 12. Protection increases the productiveness of labor and capital if it drives labor and capital out of the less produc- tive into the more productive fields. In the foregoing discussion the assumption has been made that when left to themselves enterprisers will seek out the industries enjoying the greatest natural advantages. On this assumption, all that government can do is to force industry into the less productive fields — a policy that can result only in reducing the national production. Now, while the assumption is ordinarily defensible, it is not universally valid. Enterprisers do not always know what fields offer the highest rewards. Furthermore, even if an enterpriser suspects that a given field, hitherto unex- ploited, would offer rich returns, conservatism may deter him from abandoning a field in which he is already gaining profits for a field in which he may gain larger profits, but in which he may also incur losses. The men who govern a nation may be more far-sighted and more progressive than the business men of the same nation. The former class of men may become convinced THE REGULATION OF, FOREIGN TRADE 363 that certain fields of production will be profitable long be- fore the latter class will venture into those fields. The government, by placing duties upon the products that those fields might yield, makes success a certainty. Once the new industries are established, the duties can be removed without destroying them. The industry of the nation is enriched by the addition of fields of employment that are as good or better than those already under exploitation. It must, of course, be borne in mind that this case is a rare one. It is not often that the statesman knows more about business than the body of business men themselves. Where, however, the government is manned by officials of a race intellectually superior to that of the governed, the national industry may be furthered in the way described. 13. Protection may enable an industry of more than nor- mal productiveness to surmount initial obstacles to success. Even when there exists no superiority of foresight on the part of those who make up the government, a govern- ment may often succeed in diverting industry from fields in which the natural advantages are less to fields in which they are greater. The United States has always pos- sessed special natural advantages for the production of iron and steel. What it lacked, in its early period, was training in the art of working metals. The enterpriser was unacquainted with the best processes, and he had to use labor that had not acquired the skill and the traditions necessary for efficient production. Now, the only way to acquire an art is to practice it. We had to make iron for a long time before we could be- come adepts in the art. A generation might have sufficed for establishing the industry in a particular locaUty ; but what enterpriser would have undertaken to produce at a loss through a generation in order that some other enter- priser might ultimately conduct the business with a profit ? Obviously, the case emanded governmental aid ; and the 364. INTRODUCTION TO ECONOMICS government did indeed come to the aid of the industry, through the imposition of duties on imported iron and iron wares. After a reasonable period of time the iron industry may become well established in a given locality, but if the pro- duction of iron in other localities promises ultimate success, the duties, it is urged, should be continued for the benefit of these localities. At a time when the first center of the industry is in a position to bid defiance to foreign competi- tion, other centers are still in extreme need of protection. 14. When an industry is well established within a country, protection becomes unnecessary . To-day our iron and steel industries are highly developed. There is excellent reason for believing that in many sec- tions of the country these industries could get on very well without the protection they continue to receive. In other parts of the country the industry may still be in need of protection. Now, is it expedient to continue protection as long as any part of the industry needs it .■' To do so is to enable those parts that are already able to stand without aid to levy upon the rest of the industry of the country. After an industry has been well estabHshed within a country, it migrates without great difficulty to other parts of the same country, if natural conditions warrant. When the iron industry has been established in Pennsylvania, it readily migrates to Alabama or Colorado, if natural condi- tions are as good or better than they are in Pennsylvania. Processes that are in use in Pennsylvania can be trans- ferred without cost to the other regions ; a body of workers can be induced, without great difficulty, to migrate with the industry. There is accordingly far less reason for giving governmental aid to the newer centers than there was for giving it to the original one. Accordingly, we may say that it may be advantageous to protect an industry until it is well established within the national domain ; if it is of a THE REGULATION OF FOREIGN TRADE 365 character that fits it for existence there, it will extend itself to other regions even if protection is withdrawn. 15. In practice it is difficult to determine when protection should be withdrawn from an industry. When an industry has become firnjly estabUshed, fur- ther protection is inexpedient and unjust, as it enables the industry to levy upon other industries that are self-sup- porting a tribute that it does not need. Here a practical difficulty arises. How can we determine just when an indus- try has passed through the period of infancy, and therefore should be left to shift for itself .■' We cannot find out from those who are engaged in the industry, since they are natu- rally desirous of a continuance of public aid, even though they do not need it; and those who are not engaged in the industry cannot tell. At the annual banquets of the various manufacturers' associations, the boast is frequently made that we can manu- facture more cheaply than any other nation on earth. But if Congress proposes to reduce duties, the same men soberly declare that our industries will be ruined if this is done. And shall Congress, in its search for truth to enlighten it, appeal from the manufacturers sober to the manufacturers off their guard and intoxicated with success .■■ The fact is, it is almost impossible for a government to determine just when a protective duty can be removed. As a result every nation retains many such duties long after they have lost all efficacy for doing anything but harm. Accordingly, there is good reason for the view that reckless experimentation in the establishment of new industries is to be avoided. 16. The establishment of industries that will never be able to maintain themselves without protection should be avoided. A stronger reason for cautious action lies in the fact that an industry established by the aid of a protective duty may never develop sufficiently to maintain itself without governmental aid. The natural conditions upon which it is 366 INTRODUCTION TO ECONOMICS based may be so unfavorable, relatively to the conditions in other countries, that the industry, if established here, will be destined to remain forever a burden upon the public — a pauper industry. Let us suppose that in a given branch of industry a commodity can be produced here at a cost of $1, while it can be obtained from abroad for fifty cents. Without government aid, no enterpriser can afford to under- take its production. Now, let us assume that a statesman, eager to see the United States producing every possible kind of goods, succeeds in placing a duty of fifty cents on the imported article. The price to consumers must then rise to ^i, a price sufficient to induce American enterprisers to produce the goods. After all the initial difficulties, such as training a force of men, establishing market conditions, etc., have been over- come, the cost of producing the article may fall to seventy- five cents, and remain there. This is the natural American cost of it. If the duty is removed, the foreign article will again be sold for fifty cents. The men who have put their capitals into the industry will have to close down their plants and discharge their workmen. The buildings and machinery used in the industry will probably be worth almost nothing for any other purpose. The skill acquired by the workmen, at great cost of time, perhaps, will be equally worthless. The removal of the duty, therefore, involves the ruthless destruction of means of wealth production, through no fault of the possessors of such means. The question naturally arises, is it right to call an in- dustry into existence by governmental action, and later aban- don it to the mercies of foreign competition.? There can be but one answer : It is not right. The government did wrong in calling into existence an industry that would never be able to survive unaided. It does wrong again when it abandons its ill-begotten offspring to die of starvation. If, however, the industry is not abandoned, it is a perpetual ex- THE REGULATION OF FOREIGN TRADE 367 pense to the self-supporting industries of the country. A human pauper dies in the end, but a pauper industry may live on forever. 17. Protection may serve a useful purpose in encouraging the development of industries that make no drain upon the natural resources of a country, and retarding the develop- ment of industries that destroy such resources. A protective tariff may sometimes be defended on the ground that it preserves the natural resources of a country against wasteful exploitation. If the government does not restrict international trade, we may, as a rule, assume that enterprisers will seek out the fields in which a given quantity of labor and capital will produce the largest amount of value, or the fields in which our advantages over foreign countries are greatest. Let us suppose that one of those fields is the growing of wheat. In most parts of the United States wheat culture represents a heavy drain upon the fertility of the soil. Land devoted to con- stant wheat cropping becomes almost exhausted in a gen- eration. Accordingly, when one sells a bushel of wheat, he sells not only the product of his labor and capital, but a part of the natural heritage of his country. But why should he care ? After his field is worn out, his years will probably be few. The next generation may be left to repair the wastes of this generation. Let us suppose that coal and iron mining and the pro- duction of petroleum are other industries in which we have great natural advantages. Enterprisers, if left to them- selves, would employ vast amounts of labor and capital in exploiting these natural resources. Every year we should send away from our country these commodities, represent- ing not merely the annual product of our labor and capi- tal, but also a part of our irreplaceable natural wealth. In a few generations we should be, as a nation, impoverished. We have seen that protection places a burden upon the 368 INTRODUCTION TO ECONOMICS industries in which we have, for the present, great natural advantages, in order to build up industries in which our natural advantages are less. If the industries that are nat- urally most productive are of the kind that waste the natu- ral wealth of the country, it is a statesman's proper policy to impose upon them such burdens, and so reduce the extent to which they are carried on, in favor of industries which involve no waste of resources, even though the an- nual production of wealth is thereby diminished for a time. The same argument, of course, condemns protection under other circumstances. According to conservative official estimates, we are using up, each year, four times as much lumber as we are growing. The rising price of lumber stimulates the activity of the woodsman to greater and greater remorselessness. Our mountains are denuded, and the waters, formerly held back by the forest covering and allowed to feed the rivers with regular flow, now sweep down the slopes in devastating flood. Obvi- ously, we should endeavor to stimulate importation of lum- ber ; if necessary, we should give a bounty on imports, that the price of lumber might' be reduced and our few remaining forests saved. But the destroyers of our natu- ral heritage demand protection in their pernicious pursuit, and we accord it to them. 18. Protection may serve the purpose of encouraging the development of industries that are favorable to the health of the laborer. If extractive industries, prosecuted too relentlessly, waste the natural wealth of a country, manufacturing industries, prosecuted in the same way, waste its men. The popula- tion of a manufacturing center does not usually compare favorably, in health and vigor, with the population of rural districts. Indeed, it is doubtful whether an exclusively urban, manufacturing population can in the long run escape physical degeneration. It might therefore be good THE REGULATION OF FOREIGN TRADE 369 policy in a country so largely devoted to manufactures as England to impose protective duties on imported agricul- tural products, with a view to increasing the proportion of the population employed upon the land. This would in- deed burden the manufacturing population ; it would for many years reduce the product of the national industry. But in view of the ultimate effect upon the character of the population, this policy might be a good one from the point of view of the statesman, who must consider not merely the prosperity of this year and next, but also that of the remotest generations. There are industries that in the end destroy the health of those who are engaged in them. A frequently cited case is a certain branch of the match industry, which con- demns its workers to early disability or death. Yet in many countries that industry asks for protection and gets it. Protection and encouragement to an industry that Ut- erally devours one's fellow-countrymen ! 19. A country should be able to provide itself with means for producing commodities essential to the successful conduct of a war ; and in m.any cases can m,ake such provision most conveniently through protection. A protective duty is defensible when it serves to main- tain facilities for the production of articles of national neces- sity, the supply of which might be cut off by war. War vessels can be built in Great Britain at far less cost than in the United States. In time of peace we should make im- portant savings by having our war vessels built in Great Britain. If we were engaged in a war, however, we could not have warships built in Great Britain, whether that country were hostile or neutral. Yet it is precisely at such a time that we should most need to increase our navy. Prudence there- fore demands that we should provide ourselves, in time of peace, with establishments capable of turning out warships ; and this involves giving them work to do. 370 INTRODUCTION TO ECONOMICS It is a moot question wliether the creation of facilities for constructing merchant ships stands on the same foot- ing. In former times, certainly, a merchant fleet was an indispensable auxiliary to a fighting fleet. The former fur- nished trained seamen, and many merchant vessels were capable of speedy transformation into warships. Modern methods of construction, however, have widely differentiated between merchant ships and ships of war. The former can- not be fitted out in such a way as to enable them to perform efficient service in line of battle. The crews of merchant ships are not such satisfactory material for a naval force as was formerly the case. Whether the national defense re- quires the development of a sea-going merchant fleet or not is a question for disinterested experts to determine. If it does, protection to the American merchant marine is defens- ible, despite the cost that it inevitably entails. Many industries that are not designed directly for the supply of articles of military necessity may be placed in the same class. In order that we may be able to construct ships and produce guns and other instruments of war, we must have men who are trained in metal working; and if there is no other way of maintaining such a force of workmen, we should create and maintain an iron and steel industry through protective duties. It is, however, to be borne in mind that the maintenance of an industry large enough to cover all the demand for iron and steel in time of peace can- not be urged on grounds of national defense. 20. A policy which aims to make a country completely in- dependent of the products of other countries is more likely to create weakness than strength in war. There are some writers who extend the principle in- volved to an unwarranted extreme. They would have every nation produce practically every article that it consumes, in order that in time of war there might not be the least in- terruption of supplies. These persons exaggerate the de- THE REGULATION OF FOREIGN TRADE 371 pendence of one country upon any other country against which it may at some time wage war. England, every one knows, does not produce enough grain to feed her popula- tion. Suppose that England found herself at war with the United States. That would indeed cut off American sup- plies of wheat and meat and cotton. But there are many other countries that would be glad to provision England at the rates she can afford to pay ; and as for cotton, the Eng- lish buyers would not be a whit worse off than the American sellers, cut off from their natural market. But suppose that a coalition of all the powers succeeded in destroying the British fleet, and in cutting off supplies from every source. Would not Great Britain be brought face to face with famine .' Certainly. But a coalition strong enough to do this would be strong enough to invade and sub- jugate Great Britain, even if that country were absolutely self-sufficing. Furthermore, any one who knows anything of the history of coalitions knows that none will ever be formed for the purpose of bringing the British nation to extinction. The strength of a nation in time of war does not de- pend upon its ability to produce everything that its inhabit- ants consume. Rather, it depends upon the valor and num- ber of its men, and upon its general wealth. Other things equal, a rich nation will overcome a poor one in war. Great Britain is formidable because she is rich. Now, the endeavor , to make a nation absolutely self-sufficing would end in mak- ing it much poorer than it would be if it used its resources in a more economical way. If we were to endeavor to raise coffee and tea, lest an impossible coalition of all the world might inflict upon us the hardships of dry breakfasts, we should waste so much of our energies in the attempt that we should be weakened in the event of an ordinary war, in which we may any day become involved. 21. Duties imposed by way of retaliation are seldom ad- vantageous to the country that imposes them. 372 INTRODUCTION TO ECONOMICS One further possible justification of duties designed to discourage importation requires examination. Other coun- tries impose duties upon American products crossing their borders. Therefore, it is said, we should impose import duties on the products of such countries, by way of retali- ation. Let us see whether this position is tenable. If Germany places a high duty on American meats, the persons who are injured most seriously are the German consumers of meat. The German producer of meat gains an advantage, but this, under ordinary circumstances, is not commensurate with the loss to the German consumer. The world demand for American meat is somewhat reduced, and this reduces the price of it slightly. A small injury, therefore, is inflicted upon the American producer of meat. Now let us suppose that in retaliation we levy extraor- dinary duties on German sugar. The chief sufferer will be the American consumer of sugar. The American pro- ducer will gain, but not commensurately. The world de- mand for German sugar will be reduced, and this will slightly reduce the price of it. Thus, in order to punish Germany for inflicting a large loss on German consumers and a small one on American producers, we inflict a large loss on American consumers and a small one on German producers^ But retaliation is war, and in war the petty rules of logi- cal conduct are not to be observed. The important ques- tion is this : does the policy of retaliation effect its purpose ? Will we compel Germany to remove the obnoxious duty ? In all probability, no. After the duty on meat has been in force for some time, German producers will increase their facilities for producing that article. To remove the duty and expose to the mercies of foreign competition the men who had invested their capital in good faith would be a policy as unjust as it would be unpopular. Similarly, American enterprisers would extend their facilities for pro- THE REGULATION OF FOREIGN TRADE 373 ducing sugar, and this would give them an equitable claim to a continuance of the duty. The only result of retalia- tion is the institution of permanent protection. If per- manent protection is desirable, it should be undertaken without reference to the way in which a foreign govern- ment conducts its own affairs. If it is undesirable, it should not be undertaken at all. 22. Summary. In conclusion we may say that protective duties may be defensible (i) when they make possible the introduction of an industry which in a reasonable time will compare favor- ably in productivity with industries that are already self- supporting ; (2) when they preserve the natural resources of a country from wasteful exploitation ; (3) when they preserve the vigor and progressiveness of the population through the maintenance of a just balance between manu- facturing and agriculture, city and country ; and (4) when they make possible the maintenance of industries that add materially to a country's strength in time of war. In any case such duties are a burden upon the national wealth, at the time when they are instituted, and often for an indefi- nite time thereafter, and whether the benefit to be gained is a due compensation for the burdens involved is a ques- tion demanding in each case careful consideration. Duties that are designed to raise wages or to increase the national wealth by the introduction of industries in the prosecution of which we have no special advantages, are founded in a delusion. They are rendered possible only by the fact that the ordinary mind does not weigh their unseen disad- vantages against their advantages patent to view. CHAPTER XX THE RELATIONS OF GOVERNMENT TO THE ECONOMIC ORGANIZATION 1. The economic and the legal systems of a country are, in a measure, interdependent. The economic world with the study of which we have been engaged is a world of free private enterprise. Its motive forces are the acts of individuals, each seeking to further his own material interests. When such individuals buy or sell material possessions or personal services, they take little thought of the interests of society as a whole, and are little concerned with the wishes or the will of society. Yet the will of society plays a part in all these transactions, for they are shaped with tacit reference to the law. The individual is free to pursue his own interests only within the limits set by the positive law of the land. If we attempt to contrast the present economic state with the state that would probably exist were there no political organization of society, we shall realize that the will of society, as expressed in the acts of government (employ- ing the term in its broadest sense) , has played an exceed- ingly important part in economic evolution. Without a gov- ernment strong enough to assure to each man the permanent possession of material goods acquired in ways recognized as legitimate, humanity could hardly have developed beyond the hunting, or at any rate the pastoral, stage. Without a government able to enforce contracts for the future delivery of goods and services, humanity could not have passed be- yond the stage in which the small artisan produced goods, on his own account, for a narrow local market. Progress in the art of government has been a necessary condition of S74 RELATIONS OF THE GOVERNMENT 375 substantial economic progress. On the other hand, it was in large measure progress in economic life that necessitated progress in government. Some of the most serious practical problems of to-day have their origin in the fact that political evolution has not kept pace with economic. Our political machinery, which developed under simpler economic condi- tions, appears in many instances incapable of maintaining justice under the complex conditions of the present time. 2. The basis of modern economic policy is free private enterprise, or laisser-faire. A government may limit its economic activities to the defense of private property and the maintenance of the obligation of contracts. It may assume the function of determining the conditions under which economic transac- tions are carried on, and may even interfere in their terms. It may engage directly in the production of goods and ser- vices. In the first case the government is said to pursue a "let alone" or laisser-faire policy; in the second case, a regulative or "paternalistic" policy; in the third, a social- istic policy. In general, the basis of modern economic policy is laisser-faire. It is true that the regulation of an industry by government is a not infrequent phenomenon, and the direct participation by government in the produc- tion of commodities and services is not by any means unknown. Nevertheless, an overwhelming majority of modern economic transactions are carried on by private individuals, subject to no direct interference on the part of the government. The question may arise whether the existence of protec- tive tariffs in most of the countries of the world does not make it necessary to qualify the statement that laisser-faire is the basis of modern economic policy. In effect, the United States government prevents us from buying Eng- lish steel, and compels us to buy steel of American manu- facture. Yet the method by which it does this does not 376 INTRODUCTION TO ECONOMICS resemble the method of governmental regulation, to be discussed below. The government imposes the condition that every ton of steel crossing our borders shall pay a certain tax. This condition met, the steel becomes an arti- cle to be dealt in freely. In buying or selling it men consult only their self-interest. The imposition of the duty creates a steel industry in this country; but the method by which this is done is very different from the method of governmental production. Prices are en- hanced ; and this leads individuals, in the pursuit of their private interests, to engage in steel production. The gov- ernment, as it were, creates a favorable soil in which free enterprise may flourish. We may, therefore, say that the existence of customs barriers does not render necessary a qualification of the statement that the economic policy of modern governments is based upon the principle of laisser- faire, or free enterprise. 3. The question whether the system of free private enter- prise is conducive to the greatest human welfare demands consideration. The system of free enterprise has been at once the sub- ject of extravagant praise and of savage criticism. Some writers attribute to it all the progress in civilization that the last centuries have witnessed. To these writers every en- croachment by government upon the domain now occupied by private enterprise is fraught with grave dangers. Other writers regard the system as wholly corrupt, and hope to see it replaced either by a system under which all economic activities are minutely regulated by government, or by one in which the government itself carries on all pro- duction of wealth in behalf of society as a whole. An exhaustive treatment of these opposing views would carry us far beyond the scope of the present work. We may, however, consider briefly whether, on the whole, the system of free enterprise meets the tests of justice and of RELATIONS OF THE GOVERNMENT 377 social expediency. If it does this in the main, there may yet tie a distinguishable field in which individual enterprise should be subjected to governmental regulation, and yet another field in which the government should participate in the production of wealth. A part of our task must be to find the boundaries of the respective fields, if such boun- daries really exist. 4. From the point of view of production the system of free private enterprise has proved highly effective. There can be no question that the productive power of man has been immensely increased in the two or three centuries in which enterprise has been accorded a fair measure of freedom by government. Improvements in methods of production and the formation of vast accijmu- lations of capital have reduced greatly the amount of toil necessary for the maintenance of human life. The amount of commodities placed at the disposal of the average man has been vastly increased. Relief from toil and command over commodities are not tantamount to well-being; but they serve at least as a basis of well-being. It would be unjustifiable to ascribe the entire sum of progress in production to freedom of enterprise. Many other causes have contributed to this progress ; but there is no doubt that many inventions have been made with a view to the profits that might flow from them; and the wide introduction of improved processes of production has been largely the result of the pursuit of profit. 5. From the point of view of the distribution of wealth it is not so clear that the system of free private enterprise has resulted in unmixed good. One of the patent results of the system of free enterprise has been the formation of classes differing greatly in their command over wealth. Inequalities in fortune were prob- ably never greater than they are to-day. It cannot be said that the poor are poorer than they were in earlier 378 INTRODUCTION TO ECONOMICS stages of the world's history, but it is quite possible that the wretchedness of the poor in our great and wealthy cities is greater than was the case in earlier times. The questions therefore naturally arise whether or not the existing system is just in its distribution of wealth, and whether a system more conducive to human welfare jcould not be devised. These questions involve so many consid- erations that it is doubtful whether any human mind can answer them conclusively. 6. In the apportionment of profits among enterprisers, a measure of justice and social expediency is discernible. We may first inquire whether the existing system tends toward justice from the point of view of those who direct production, the class of enterprisers. Under competition any enterpriser may engage in any branch of production, and create and sell wares to his best advantage. Any enterpriser may make a calculation of costs and prices in the various branches of production. If prices are high in any one field, relatively to cost, new enterprisers press into the field ; the supply of the commodity is increased, and its price falls. It follows that there is a tendency for the various classes of goods to exchange, one for the other, in proportions corresponding with their respective costs of production. When this point has been reached, justice, as between different enterprisers, has been established. At any given time, it is true, some enterprisers receive greater rewards, in proportion to their outlays, than others. But if competition is free, this can happen only when not enough of one commodity is produced and too much of an- other. The high rewards given to enterprisers in the one field are an inducement to the expansion of production in that field ; the low rewards in another field give warning that less of the product of that field is wanted by society. The unequal treatment of enterprisers is the means by which society compels them to direct their forces in such a RELATIONS OF THE GOVERNMENT 379 way as best to meet society's needs. The inequalities are salutary in their effects ; when there is no longer an im- proper distribution of productive energies, they cease to exist. 7. There is a tendency toward fairness in the distribution of rewards among the different classes of workmen and among capitalists. In a similar way, the system of free enterprise tends to establish justice as between different classes of workmen. If in any industry wages are above the average, due allow- ance made for relative agreeableness and safety of employ- ment, labor tends to flow into that industry from industries in which wages are below the average. Wages then fall in the former industry and rise in the latter. The initial inequalities in wages signified that there was too much labor in some fields, too little in the others, and the very fact of inequalities of reward helped to correct this condition. Justice is done as soon as social expediency permits. Simi- larly, there is a tendency toward equality of rewards for invested capital. 8. The question of justice, as between the different eco- nomic classes, admits of no definite answer. The existing distribution among such classes may be justified, perhaps, on grounds of social expediency. Can it be said that the system of free enterprise insures justice in the relations of enterprisers, capitalists, and labor- ers with one another .? There is no way of weighing the sacrifices Undergone by those who direct industry against the sacrifices of those who furnish capital and of those who labor. We can, however, weigh the services to so- ciety of the respective classes ; and we can say that there is a tendency for rewards to proportion themselves to ser- vices. This is not equivalent to saying that the distribu- tion thus based on services is just. For how came the millionaire into a position where he can serve, as it were, 380 INTRODUCTION TO ECONOMICS by proxy — his millions bringing him great rewards, while the laborer, serving in person, receives but an insignifi- cant return ? From the point of view of social expediency, however, it seems more plausible that a distribution based on service is satisfactory. Assuring to the capitalist the fruits of his capital encourages the formation of new and greater capitals, and these are powerful instruments for increasing the social production and hence for improving the economic condition of all. 9. When the pai'ties to a contract are unequal in skill and strength, injustice is likely to result. An economic system based upon free contract will be just and socially expedient only when the parties to each contract stand on a footing of substantial equality. In the first place, the buyer must know the properties of the goods offered to him as well as the seller knows them; the laborer must know the risks and inconveniences attach- ing to a given employment as well as the employer knows them. When an unscrupulous horse dealer foists upon an unsuspecting buyer an animal with a hereditary taint of character or defect of body, the social welfare is in some degree reduced. The seller receives wealth, not for his services, but for his rascality; the buyer parts with his money, not for utilities, but for " experience." If all trade were of this nature, as it was among the ancient Greeks, we should, like the ancient Greeks, regard trade and piracy as twin callings. 10. Free enterprise results in approximate justice only under competition. In the second place, the buyer must be in a position to deal with any one of several sellers, each acting independ- ently of the others, and the seller must be able to offer his wares to any one of several independent buyers. The laborer must have the option of selling his services to any one out of a number of independent employers, and the RELATIONS OF THE GOVERNMENT 381 employer must have the option of selecting from among a number of workmen. In other words, competition must exist on both sides. Otherwise the seller or the buyer, the laborer or the employer, is in danger of being forced to accept terms that are manifestly unfair. And this can issue only in the discouragement of production, and hence in economic decay. Of the two conditions stated, the latter — the existence of competition — is the more important. If competition is active, the seller of wares will point out their good qualities, and his competitors will point out their bad ones. Even an ignorant buyer is thus in some measure protected against injustice. When one party to a contract has no competitors to fear, knowledge on the part of the other party is of httle avail. There is a certain town which I can reach only by traveling over a particular railway line. The line is in very bad shape ; the ties are rotten and the rails are light ; the cars are old and unsanitary. Travel on this line involves an unduly large measure of danger and discomfort, and I know it. Yet I must buy tickets over the line, because I have no alternative. 11. The government must regulate the conditions and terms of economic contracts when its failure to do so results in substantial injustice. Now, if there were merely sporadic cases in which con- tracts are made under conditions that make possible a wide departure from fairness, there would be little need for governmental intervention. But when there is an ex- tensive field in which such conditions prevail, the need for governmental intervention becomes imperative. In early times the producer and the consumer were, as a rule, neighbors. The tailor and his customer lived in the same village. If then the tailor worked under unsanitary conditions, the customer had a chance of knowing it. If the tailor substituted inferior materials, trusting to the 382 INTRODUCTION TO ECONOMICS customer's ignorance, the deception was likely to make it- self known in the wearing of the garments, and react un- favorably upon the tailor's business reputation. Fair dealing, under the circumstances, was a prerequisite of business success, and the man who dealt dishonestly sooner or later reaped the due harvest of his misdeeds. To-day the man who makes your clothes may live a thousand miles away from you. He may be suffering from a mild attack of smallpox as he works upon your garments. You cannot see the danger that lurks in them. The milk that you drink may come from a dairy one hun- dred miles away, where no attempt is made to prevent its contamination with the germs of disease. The appearance of the milk gives you no warning of the fact. Patent medicine manufacturers may for years have supplied you with remedies containing dangerous amounts of opium ; packing houses may have furnished you with meat treated with preservatives that undermine your health. Only an expert can tell you whether this is true or not ; and you can probably ill afford to employ a corps of ex- perts to investigate the hidden qualities of the things you buy. The workman in a large factory is in a similar position of helplessness. He cannot estimate the degree of danger that unfenced machinery represents. He cannot tell whether ventilation is adequate, or whether dust and nox- ious gases are properly disposed of. Furthermore, he is often unable to judge correctly as to the number of hours that he can toil daily without undermining his health. Not less significant than the separation of consumer from producer has been the development of combinations of producers. In many fields, buyers have virtually only one seller to deal with. In this state of affairs, there is no way in which the consumer can enforce a demand for wares of good quality, if wares of poor quality are more RELATIONS OF THE GOVERNMENT 383 profitable. The employee of a monopoly may know that unsanitary conditions prevail in its shops, but he may be unable to find other employment. Furthermore, the prices of monopolized products are likely to be unreason- ably high, and this means that the monopolist takes from the aggregate income of society a larger, share than his services warrant. 12. The government may be called upon to regulate the quality of goods or of services. Governmental regulation of the quality of commodities was exceedingly common in the Middle Ages. The weight of the loaf of bread, the width and quality of fabrics, were determined by public authority. With the development of modern industry much of this regulation fell into disuse. Competition was permitted to regulate the quality of com- modities as it regulated their prices. The mediaeval kind of regulation has, however, survived in a few instances, where the retention by a country of a valuable branch of trade for- bids individualistic tampering with the traditional standards of quality. The Persian government endeavors to suppress the use of aniline dyes in the manufacture of rugs, on the ground that the employment of these dyes will ultimately destroy the foreign demand for Persian rugs. The Japanese government inspects all mattings produced for export, and regulates their quality. The regulation of the quality of goods in most modern states has for its chief purpose the preservation of the public health. The use of certain ingredients in foods is forbidden; the use of other ingredients is limited to certain fixed pro- portions. An attempt is made to insure the production of many classes of goods under conditions limiting the risk of transmission of disease from worker to consumer. No at- tempt is ordinarily made to protect the consumer against fraud, so long as such fraud does not involve injury to health. 384 INTRODUCTION TO ECONOMICS The regulation of quality is carried farther in the case of certain goods and services furnished by enterprises en- joying a monopolistic position. The quality of gas to be furnished to the inhabitants of a city by a private company is commonly determined by public authority. The service of passenger transportation by street and steam railways is often subject to regulation as to quality. In these cases regulation is often defended on the ground that the enter- prises are of a quasi-public nature. But any enterprise which obtains a monopoly of a branch of production is, from an economic point of view, in-the same position. If a powerful mon opoly controlled the iron and steel business of the United States, there would be no way, except governmental regula- tion, of preventing the use of ores rich in phosphorus or sulphur in the production of iron destined to be transformed into steel rails. This would be a menace to the safety of all travelers ; it would therefore be necessary in the end for government to regulate the quality of steel produced. There is, of course, a danger that the government may go so far in the regulation of quality as to check legitimate improvements. By the aid of certain chemicals, wheat flour of a darkei' color than consumers like may be bleached to a snowy whiteness. The chemicals are admittedly injurious to health ; but they are inevitably driven off, either in the process of flour manufacture or in the baking of bread, so that hardly a trace of them can be found in the latter prod- uct. Yet there is some public sentiment in favor of prohibit- ing the bleaching of flour. In spite of the danger of over- regulation, however, it must be admitted that the principle of regulation of quality is salutary, and that the scope of regulation is destined to extend itself in future. 13. A government may regulate the prices of commodities or services. Governmental regulation of the prices of commodities and services was also exceedingly common in the Middle RELATIONS OF THE GOVERNMENT 385 Ages. In modern times such regulation is limited to the field of the so-called gieast-p\ihlic enterprises. The charges of railway, companies, of gas and electric light companies, of telephone and telegraph companies, and evezi of such petty enterprises as the carriage of passengers in cabs and similar conveyances, are commonly regulated by law. Such regulation is not actually based upon any economic ground, but upon the legal ground that the enterprises in question perform functions that the state has often per- formed, use the public highways, or employ public powers in obtaining rights of way. From an economic point of view, all the enterprises mentioned except the last ought to be subject to govern- mental price regulation, because they are monopolies. Without such regulation, a railway company might, if it chose, levy such heavy charges upon the carriage of goods away from and into a particular locality as to destroy the business of that locality and reduce the value of property situated there to almost nothing. If the railway is the only means of transportation from a mining district, by raising rates it can reduce the profits of mine owners to nil and force the closing of the mines. It can then buy up the mines at a very low figure, and operate them profit- ably on its own account. True, this is an extreme case; yet it illustrates very well the evils that an unregulated monopolistic determination of transportation charges would entail. If a monopolistic combination succeeded in gaining con- trol of the entire iron and steel industry, or of the business of mining coal, its powers for extortion would be as great as those of the railway in our example. What would one give rather than pass a Northern winter without coal? Not all that one has, but a good part of it. If we must inevitably see an extension of monopolistic enterprise, as many believe, it is inevitable that we shall see an extension of the principle of governmental price regulation. 386 INTRODUCTION TO ECONOMICS 14. A government may regulate the conditions under which labor is performed. So long as economic organization remained simple, there was comparatively slight need for governmental regula- tion of the conditions under which labor was performed. A large proportion of those who toiled were their own em- ployers, and these could be counted upon to keep their work places in tolerably sanitary condition, and to limit their hours of labor and the intensity of their exertion to the degree that considerations of health demanded. Those who worked for wages enjoyed, as a rule, conditions as favorable as those of the workmen who were in their own employ. The advent of the factory system changed conditions materially. Men, women, and children were congregated in great masses, under the supervision of overseers, many of whom were bent upon getting the maxi- mum possible service from the workers under them. Ma- chinery took a place in the productive series, and the workers were forced to adapt themselves to the speed of the machines. Competition between manufacturers led at first to a longer and longer working day, and to greater and greater intensity of effort. The worker, seeking em- ployment, was in no position to stipulate that the working day should be limited to a reasonable number of hours, or that the labor should not be so intense as to be destructive of the health of the laborer. Society, it is clear, cannot afford to see the vitality of its working classes sapped in an effort to raise to its maxi- mum the annual production of wealth. An individual employer may profitably pursue the policy of hiring a set of workmen, wearing them out in a few years, and replac- ing them by another set. From the view point of society this policy is as wasteful as it is cruel. The daily exertion of each man should be restricted to such measure that he may live a life of normal length, enjoying the normal num- RELATIONS OF THE GOVERNMENT 387 ber of years of health and usefulness. Where labor in- volves little strain, a man may work ten hours or more a day without injury to health. Where the strain is great, eight hours may be an unduly long workday. When laborers are associated in strong unions, they may be able, without governmental aid, to reduce the hours of labor to the measure that is desirable from a social point of view. Each organization is composed of workers of all ages, and there is a natural tendency to maintain a pace that is not too rapid for the older workers, hence not so rapid as to destroy the physical health of the younger men. But strong trade unions control only a small part of the economic field. Such associations are especially weak in industries employing large numbers of women and chil- dren, and these are precisely the classes that are most seri- ously injured by long hours of work. Hence it has come to be generally recognized that the conditions under which women and children work in factories ought not to be left to free contract. Hours of labor, for these classes, must be regulated by government. In almost every modern state some attempt is made to regulate by law the hours of labor of children employed out- side of the household. Such regulation has been carried farthest in the states where the system of large scale produc- tion has long been established, as, for example, in England. In new industrial states, as in Japan, the regulation of the hours of child labor is only in its inception. The regulation of hours of labor of women employed under similar circumstances is also a well established policy in the more advanced states. In the United States a serious obstacle to such regulation is found in constitutional provi- sions, originally designed to secure the liberty of the indi- vidual, but now operating in such a way as to obstruct his chances of attaining freedom from industrial slavery. The regulation of hours of labor of men has as yet made com- 388 INTRODUCTION TO ECONOMICS paratively slight progress ; the policy is, however, destined • to extend its scope in the future. The regulation of other conditions of employment — ventilation, sanitation, etc. — has encountered comparatively few positive obstacles. The field is, however, so wide, and the work of legislatures so slow, that hundreds of thousands of workmen are to-day employed under conditions involving needless risk of mutilation and death. Still greater is the number employed under conditions that predispose the worker to disease. Progress in the direction of regulation of such conditions is steady, but dishearteningly slow. 15. The government may regulate rates of wages. The regulation of wages is a policy very seldom em- ployed in modern times. Doubtless there are many cases in which wages are far below the level of productivity of labor; and in these cases it is manifest that injustice is done. To attempt to fix general wages by law, however, is to en- counter grave difficulties. If in any industry wages were fixed at a level that seemed to the workers too low, the lat- ter would feel justified in refusing to work. If the level of wages seemed to employers too high, they would feel justi- fied in closing their shops. To force the laborers to abide by the rate determined by government would be to inaugu- rate an era of universal serfdom. Men would be compelled to work on terms fixed by others, and this is the essence of serfdom. To force employers to continue production, paying wages that seem to them unduly high, would be to confiscate property. In either case it is likely that economic progress would be checked. This does not mean that it would not be possible to se- lect certain industries, in which the laborer is most seriously exploited, and establish minimum wages there. If the rate were too low, some of the laborers could seek other em- ployment. If the rate were too high, some of the employ- ers could remove their capital to other industries. With RELATIONS OF THE GOVERNMENT 389 the shrinkage in the volume of the industry, the price of its products would rise, and this would enable the remaining employers to pay the rate of wages fixed. True, some of the workers formerly in the industry would be left without employment. Some means would have to be found for transferring them to other employments. However this might be, such regulation, limited to a few fields, would encounter no insuperable obstacles, and might result in alleviating the distress of some of the most helpless mem- bers of society. Some such policy as this has been inaug- urated in one of the Australian colonies — with what results, we shall better know after the lapse of another decade. 16. Governmental regulation of the relations of capitalists and enterprisers is, in some cases, necessary. Regulation of the relations between enterpriser and capi- tahst, or between borrower and lender, tenant and land- lord, has largely fallen into disuse. In modern times the man who borrows capital is usually possessed of some property and of at least an average degree of business ca- pacity. It may therefore be taken for granted that he will not subscribe to terms that are not to his advantage. If a man is willing to borrow capital at ten per cent, there is good reason for believing that the annual use of the capital is worth to him at least ^10 per ^100. Accord- ingly, there is no reason why the public authority should interfere in the transaction. Many of our states do indeed have usury laws, limiting the rate of interest that may be paid. But these laws are easily evaded, and may be re- garded as obsolete. Where the enterpriser is a corporate body, as is commonly the case in large scale production, the relations between those shareholders who are actually in control and those whose voice in the management is seldom heard, often require regu- lation. The small investor in a large corporation is often 390 INTRODUCTION TO ECONOMICS at the mercy of a group of large investors, who manage the property in their own interests, not in those of the entire body of stockholders. Something akin to the con- fiscation of property takes place when the men in control of a corporatiori undertake a " shaking out " of the " little men." There is probably no class in the United States to-day more in need of governmental regulation than these "little men." In the end, doubtless, regulation will come, and the small investor in a corporation's stock will know whether he is buying property or shadowy hopes, and whether or not he will be permitted to keep what he has purchased. Relations between landlord and tenant assume the guise of a social problem wherever the ownership of land has become divorced from its cultivation. Where a small number of large landholders deal with a vast number of small tenants there is often opportunity for the oppression of the latter. The tenant who brings a tract of land into an excellent state of cultivation should not be evicted by the landowner without fair compensation. Justice demands that he should be permitted to retain his occupancy of the land until he has reaped the fruits of his labor. Upon the renewal of his lease he should not be compelled to pay an additional sum for the use of the productive powers that he has himself created. A wise landlord, it is true, will not deal unjustly with tenants who increase the productive power of his land ; but not all landlords are wise. The tenant may, in some measure, safeguard his interests by the terms of the contract under which he enters upon his tenancy ; but not all the conditions that may arise during a term of tenancy can be covered by a formal contract. Accord- ingly, the state, under the conditions assumed, may be called upon to regulate the relations of landlord and tenant in such a way that the latter may proceed confidently with the improvement of the land, knowing that he cannot be de- RELATIONS OF THE GOVERNMENT 391 prived of his due reward. No general problem of this na- ture has arisen in the United States. This is due to the fact that it is easy for any energetic cultivator to acquire land of his own. It is quite conceivable that at some future time, when the rising price of land and the resultant concentra- tion of holdings have given rise to a permanent class of tenant cultivators, the regulation of the relations of land- lord and tenant will assume great importance. 17. Governmental regulation does not change the funda- mental characteristics of the existing economic system. The foregoing survey is sufficient indication of the fact that the regulative activities of government already cover a wide field, and we have excellent reason for be- lieving that the scope of such activities will in the future be greatly extended. In so far, we are drifting away from an economic system based upon free private enterprise. It cannot be said, however, that the essential nature of the existing economic system is thereby altered. That system is based upon private initiative; and though the govern- ment may restrict the field in which private initiative finds exercise, it does not bind initiative itself. The government may prohibit the production of certain articles. In so doing it warns private enterprise away from a limited field ; but there remain other fields open. The government may fix the price at which a certain article may be sold, but this price must be left high enough to tempt private enterprise into the field; otherwise the article will not be produced. The government may prohibit the employment of certain classes of persons, and restrict the hours of labor of other classes. Private enterprise is still called upon to furnish employment, and the conditions may not be made so onerous as to exclude the possibility of liberal profits. A system of regulated enterprise is none the less a system of private enterprise. A range of choice and an opportunity for gain are left open to the enterpriser, and if enterprise is really active, it is 392 INTRODUCTION TO ECONOMICS forever creating new opportunities beyond the reach of regulation. It may appear that while the existing system of eco- nomic organization is in no danger of subversion through the extension of governmental regulation, it is in danger of being supplanted by a system of governmental enterprise, or a socialistic state. We have already many examples of direct production of commodities and services by the state ; and we may predict an increasing number of such enterprises for the future. Must we therefore believe that a time will come when the state will enter all branches of industry, and organize the whole working population as a civil service corps .'' We shall get some light upon this question from a study of the reasons that have led to the direct participation of government in industry. From such a study we may draw inferences as to whether or not the same reasons will lead to an indefinite extension of the principle of governmental enterprise. 18. A government may take over an industry for the pur- pose of securing a revenue from the profits of the industry. In some instances, the production of a commodity or a service is undertaken by government solely with a view to securing a revenue. This is the case with the tobacco monopoly of France and of some other countries, the salt monopoly in British India, and a few other public monop- olies. The profits of the business take the place of reve- nues that would otherwise be raised by taxation. The government of France, instead of operating a tobacco monopoly, might levy duties on the manufacture and sale of tobacco. If the policy of a government monopoly is resorted to, the product is sold to the public at a price exceeding cost of production. This excess of price repre- sents the net revenue. Let us say that in a given country the price will be so high as to yield a net revenue of ;^20,ooo,ooo. Now, the government might place a tax RELATIONS OF THE GOVERNMENT 393 yielding ;^20,000,000 on the' private manufacture of the article. The manufacturers would add the tax to the price paid by the consumers. In either case the government would get the same revenue. In either case the consumer would bear the burden. Which is the better poUcy, then, a government monopoly or a tax yielding the same revenue ? Under private enterprise the price of tobacco will be determined by cost of production plus the tax. Say that the aggregate cost of production of all the tobacco used in the country is $40,000,000. Add to this a tax of $20,000,000, and the consumers will have to pay about $60,000,000 for it. Under government enterprise, what will it cost to produce the tobacco .■' The government can borrow capital at a lower rate than private enterprisers ; it is likely to pay higher wages. Laborers in the employ of the government are not likely to work so hard as those in the employ of private persons. Let us therefore say that the production of tobacco costs the government $50,000,000. To this add $20,000,000 profit for the public revenues, and the consumers will have to pay $70,000,000 for what they would have paid $60,000,000 under private enterprise, subject to excise taxation. From this example the following principles may be drawn : When the cost of production in governmental shops is greater than the cost in private shops, with a given burden upon the consumer a larger revenue can be obtained by the government through taxation than through governmental enterprise. The cost of production is or- dinarily greater in governmental shops than in private shops. There is accordingly little reason for an expansion of governmental enterprise for the sake of obtaining revenue. 19. TAe government may assume control of an industry for the purpose of regulating the quality or the price of the product. 394 INTRODUCTION TO ECONOMICS The assumption by governments of the sole right to coin money is an illustration of an industry undertaken by gov- ernment for the purpose of regulating the quality of the product. Imagine the inconvenience of a currency com- posed of coins struck by all the private companies that mine gold or silver ! Some would be light weight, some heavy ; some would have much alloy, some little. Obvi- ously, absolute uniformity and absolute conformity to well- known standards are essentials of a currency employed in a modern state. And such uniformity and integrity of quality can be secured only when the coins are issued by an organ of society which regards the interests of society as paramount. Doubtless it costs more to coin money in government establishments than it would cost in private establishments. But this waste is insignificant as com- pared with the gains from a currency of unquestioned soundness. A similar reason has led to the nationalization of the railway in many countries, and to a popular demand for nationalization in other countries. If we could be sure that private railways would furnish good service, at equal terms to all, and at reasonable charges, we should never regard government ownership of railways as desirable. But of this we cannot be sure. We have tried regulation, and are still trying it ; and it may be that we shall succeed in our endeavors to secure impartial and reasonable treatment of shippers and travelers. If we cannot do this, we shall in the end make up our minds that the railway is to other business enterprises what the coinage is to other com- modities — an essential link in almost every business trans- action — and that its social aspects are of paramount importance. A similar argument applies to the so-called municipal monopolies — street railway transportation, the furnishing of water and light, and the telephone service. If it is im- RELATIONS OF THE GOVERNMENT 395 possible to regulate the quality and the price of service under private management, public management becomes necessary. It is, however, to be borne in mind that such regulation is impossible only when the people are unable to select able and honest officials ; and when such is the incapacity of the people, governrnent enterprises stand little chance of being managed efficiently and honestly. 20. Where the utilities created by an industry are not appropriable, government operation becomes a necessity. In the foregoing instances there is no inherent necessity for public operation of industry. In the first case this policy is adopted in lieu of a policy of taxation ; in the other cases, in lieu of a policy of regulation. We come now to consider cases in which government enterprise is necessary, because it is the only means of securing certain important utilities for society. In some branches of industry, practically all the utilities created embody themselves in a concrete form, so that the producer is able to recoup himself for his costs of production through sale of the utilities to those who are to enjoy them. The utilities created by a shoe manufacturer are embodied in the shoes ; and the manufacturer can obtain from the user of shoes a price that will compensate him for his expenses. If the consumer will not pay enough to cover costs, the shoes ought not to be made, for there are no utilities arising from their making that the con- sumer cannot appraise. We may contrast with the utiUties furnished by such an industry the utilities furnished by a lighthouse. These are scattered far and wide over the waters that are rendered safe by the light. They benefit every shipowner whose vessel sails in these waters ; every passenger for whom the danger of death at sea is thereby reduced ; every shipper who pays lower freights because of the smaller chance of the foundering of ships. In a year's time the 396 INTRODUCTION TO ECONOMICS utilities contributed by the lighthouse may far exceed its cost of maintenance. But if you or I were to erect a lighthouse, how would we collect pay for these utilities from the beneficiaries ? Clearly, this is no field for private enterprise, and yet it is a field in which labor and capital may produce greater utilities than elsewhere. The gov- ernment, as the representative of society, can alone afford to exploit this field. Again, an industry may produce some utilities that are concrete and appropriable, and some that are elusive, flow- ing freely to persons who cannot be made to pay for them. In a very slight degree this is true of all industries ; but we are concerned only with cases in which this differentia- tion of utilities is Well marked. We may take as an example common school education. The children who receive instruction are the immediate beneficiaries ; they, or their parents, could be made to pay something for it. But all of us who wish a government of officials selected by intelligent voters ; all of us who prefer intelligent and efficient employees to ignorant ones ; all of us who wish to enjoy the products of a rich and varied national produc- tion, — are the indirect beneficiaries. A great part of the total benefit from educating a child is reaped by persons not connected with him by ties of blood or personal interest. Now, if the benefit to the child is so great, and so clearly appreciated by him or by his guardians, that the entire ex- pense of education can be met by tuition, we who are also beneficiaries may take our gains gratis. But if this is not the case — and, as a rule, it is not — we should be very shortsighted if we refused to contribute our share to the expenses of his education. From a social point of view the benefits of popular education far outweigh the ex- penses of it, the expenses cannot in each case be assessed upon the beneficiaries; therefore the production of the utilities in question must be undertaken by government. RELATIONS OF THE GOVERNMENT 397 Another case may now be cited. Near one of our large cities there is an island which is capable of providing building lots for a large population. Until recently com- .paratively few persons could make the island their home, on account of the uncertainty and inconvenience of passage to the city. A ferry service existed, but the boats were small, old, and slow. The owners of the ferry line could not furnish better service, however, because the increase in fares would not cover the increase in expense. The introduction of an efficient ferry service would have greatly increased the value of land on the island ; it would have furnished an outlet to some of the surplus popu- lation of the city, and diminished the evils of overcrowding in tenements. These utilities might very well have been of sufficient annual value to offset the increased cost of service. But the private ferry company could collect no charge for such utilities ; therefore it could not make the improvement. The city, on the other hand, could very well afford to estab- lish a satisfactory service to the island, since the city as a whole would get most of these elusive benefits, in addition to the fares it would collect from passengers. It is obvious that the same principle may be extended to a great many enterprises — street railways, steam railways, ptc. At any given time most of the utilities produced by such an enterprise as a street railway system may be of such a character that a price can be charged for them. As the city grows in size and questions of transportation assume greater and greater importance, the utiHties that are not appropriable increase in number and in value. In the end, these utilities may come to be of such significance that the transit system ought to be managed chiefly with reference to them. In such case public ownership ought to take the place of private ownership. Now, as population increases, the industries producing non-appropriable utilities, along with those that are appro- 398 INTRODUCTION TO ECONOMICS priable, become more numerous — or, more exactly, the non-appropriable element in utility production becomes more important, relatively to the appropriable element. Accordingly, an expansion of public enterprise, in this di- . rection, seems probable. 21. When private e^iterprise is too weak to enter upon a productive field, government enterprise is sometimes neces- sary. One further case in which public enterprise may enter the field of production may here be touched upon. Some- times private enterprise is not sufficiently daring or skillful to enter upon the supplying of utilities even when there is no obstacle in the way of charging a price for them. The government, if under the control of able administrators, may then increase the social welfare by undertaking production directly. When a country, long habituated to one mode of economic life, is suddenly compelled to adapt itself to new conditions, this superiority of public to private enterprise may manifest itself. In the last half century many enter- prises have been undertaken by the Japanese government, in fields ordinarily left to private business. As a class of enterprisers developed, the control of such business has been gradually transferred to them. When, on the other hand, initiative dies out in a people, owing to the weeding out of the more intelligent and enterprising elements in the population, the government may gradually assume con- trol of production and trade. Something of this nature oc- curred in the later years of the Roman Empire and in the declining period of Venetian history. So long as there remains in society a large class of per- sons possessing enterprise and ingenuity, there is little reason for believing that the extension of the field of public enterprise will really narrow the field of private enterprise. For the boundaries of the latter can be extended indefinitely outward, so long as men have wants that remain unsatisfied. RELATIONS OF THE GOVERNMENT 399 Public enterprise will supplant private enterprise only when the latter has become impotent to direct the supply- ing of the needs of society. 22. Summary. The basis of the modern industrial system is free private enterprise ; such apparent violation of the principle as a protective tariff represents does not alter its fundamental truth. The system of private enterprise has proven highly ef- fective in the field of production ; in the field of distribution it is impossible to give an unqualified opinion as to the justice and expediency of the system. Unregulated private enterprise gives rise to serious evils which demand govern- mental intervention. In general, wherever gross inequality appears in the bargaining power of parties to contracts, governmental regulation is necessary. The government may be called upon to regulate ( i ) the quality of commodities and services; (2) the price of commodities and services ; (3) the condi- tions of labor ; (4) the wages of labor ; (5) the relations between capitalist and enterpriser. -Governments often participate directly in industry. The purpose of public enterprise may be merely the secur- ing of a revenue. This end may usually be better attained through taxation of private industry; hence extension of governmental enterprise to this end is improbable. The government may take over an industry in order to regu- late effectively the quality or the price of the product of the industry. Public enterprise having this object is likely to become more common with the development of society. The government may take over industries, the utility-pro- duct of which is not readily appropriable. Public enter- prise of this nature is also likely to increase in importance. The government may found industries when private enter- prise is lacking in efficiency. INDEX Agriculture, combinations in, 139-40. American Federation of Labor, 181 ; 183. Apprenticeship, regulations of trade unions, 176-78. Arbitration, 185-87; compulsory, 187-88. Bank, ch. XVI ; functions of, 281-87. Bank credit, as a substitute for money, 300. Bank deposits, origin of, 291-93. Bank loans, character of, 290. Bank notes, 297-300. Bank reserve, 294-95. Bank, savings, 317-19. Banking, safety of, 296-97. Barter, in international trade, 337-38. Bills of exchange, 284 ; 338 et seg. ; effect of changes in price of, 344-4S ; 353- Bimetallism, 259; 262; 272-74. Bonds, 306. Boycott, 182-84. Broker, 321-22 ; 310. Building and loan association, 319-20. Buyers, marginal, 40-41. By-products, 129-30. Capital, ch. XII ; artificial and natural, 197-99; as affected by increase in labor, 100-01; definition of, 193-94; increase of, effect on wages, 204-05; measured by cost of replacement, 228- 29 ; natural, as affected by increase of artificial capital, 207-08; permanence of, 194-96; productive and acquisi- tive, 196-97 ; productivity of, 200 et seq.; productivity of, as affected by risk, 211-13 ; tendency of, toward equalized productivity, 209-11; trans- fer of, 280 et seq. ; 303 et seq. Capital goods, 192-93; productivity of, 199 et seq. , revaluation of, 208. Capitalization, 228-31; of profits, 248- 49. Charging what the traffic will bear, 74- 75- Checks, 287-88. Child labor, 117; 387. Classes, economic, 16-18; 377-78' Clearing house, 293-94. Closed shop, 175-76. Coinage, 394 ; free, 258-60. Collective bargaining, 173-74 ; 184-85. Combinations, ch. IX; 50-51; in agri- culture, 139-40; in railway business, 138 ; partial, 140-41 ; relation to concentration, 137; temporary, 139- 40. Competition, 14-16 ; as affecting mo- nopoly price, 65-66; between laborers in different employments, 163-64 ; potential, 66; regional, 87-89; relation to enterprise, 237-38; relation to prob- lem of justice in distribution, 380-81; restrictions upon, 16. Concentration, ch. V]II; as affected by concentration of wealth, 124-25; as affected by improvements in trans- portation, 123-24; as affected by law of diminishing returns, 134-35; ^s affected by railway discriminations, 132; dependent upon corporate form of organization, 125-26; in agriculture, 122-23; of wealth, 124-25; relation to combination, 137 ; statistics of, 121-22. Conciliation, 187. Consolidation, 141 ; \^\et seq,; 149. Consumer's goods, 4; 192-93. Consumption, 8. Contract labor, 241-43. Coolie labor, 241-43. Cooperation, 9. Corporation, 125-26; 390. Cost of production, ch. V; 238; as de- termined by price, 89-90 ; as determin- ing price, 48-49 ; 59 ; 89-90 ; marginal, relation to value, 55-59 ; relation to international trade, 334-37. Cost of replacement, as a measure of capital, 228-29. Credit, 282-83; effect on value of money, 266-67. .Credit instruments, 283-84. 400 INDEX 401 Debt, public, origin of, 304-05. Demand, definition of, 39: elasticity of, in relation to monopoly price, 68-69. Demand a supply, 39 et seq. : in relation to price of exchange, 339 ei seq. Deposits, bank, origm of, 291-93. Differentiation, economic, ch. VII; con- ditioned by commercial organization, 109-10; dependent upon economic system, 112-13 ; dependent upon trans- portation facilities, 110-112. Diminishing returns, ch. VI ; applicable to division of labor, 118-20 ; applicable to principle of concentration, 134-3S ; counteracted by improvements, 103-04 ; from increased supply of labor, 100-01 ; general law of, loi ; in agriculture, 95-97 ; in urban improvements, 97-99 ; in transportation, 99-100; relation to law of wages, 154 ; to capital, 201-04 ; 207. Diminishing utility, 24-25. Discounts, 289. Discriminations, monopolistic, 71-76. Distribution, 9, Division of labor, no; advantages of, 113-16; as stimulating invention, 116; disadvantages of, 117-18 ; subject to law of diminishing returns, 1 18-19. Duties, protective, 353-54 ; revenue, 353. Economic classes, 16-18. Economic systems, ancient and mediae- val, 12-14; modern, iz et seq. Economics, as a developing body of thought, 12; definition of, 7; 19-20; evolution of, 9-10 ; object of, 9-11, Economy in production, 101-13. Education, common school, 396-97. Enterprise, ch. XIV ; as involving risk, 236-37 ; definition of, 234-36. Enterpriser, 235. Entrepreneur , 235. Exchange as a cause of economic differ- entiation, 107-08; as affecting per- sonal values, 32-34. Exchange, bills of, 338 et seq. ; effect of fluctuating prices of, on exports and imports, 344-45 '. 353- Exchange economy, 12-14. Exchange value, personal, 34-35. Exports, diminished by protection, 355- 56; of gold, 346-47; taxes on, 350. Exports and imports, affected by ch.inges in price of exchange, 344-45. Finance, 280. Foreign exchange, 338 et seq. Foreign trade, regulation of, 10, Free enterprise, 375 et seq. Free silver movement, 272-74. Gold, exportation and importation of, 346-47 ; increase of, effect on prices, 263-65. Gold point, 344. Good will, 246-49. Goods, 4 ; capital and consumers', 192- 93 ; definition of, 23-24. Government, relation to industry, ch. XX. . Government ownership, 392 et seq. Government regulation, conditions re- quiring, 381 et seq. Gresham's law, 261-62. Holding company, 143-44 ; 317- Imitation, as affecting personal values, 30-32- Imports, affected by price of exchange, 344-45 ; of gold, 346-47 ; reaction upon exports, 355-56. Improvemenls in production, effect on wages, 160-61. Infant industries, protection of, 363- 65. Insurance, trade union, 178. Insurance company, 320-21. Integration of industry, 138-39. Interest, ch. XIII; as affected by in- crease of capital, 204 et seq. ; decline in, effect on wages, 161-62; equiva- lent to net rent, 218. Interests, conflict of, 50-51. International trade, ch. XVIII ; affected by improvements in transportation, 328-29 ; as barter, 337-38 ; relation to cost of production, 334-37. Inventions, relation to division of labor, 116. Investment company, 316-17. Investments, 307 et seq.; demand for and supply of, 303-06 ; productivity of, 308-10; security of, 307-08; transfer- ability of, 308. 402 INDEX Joint products, 54-55. Justice in distribution, 378-81. Labor, apportionment of, 163-64; con- tract, 241-43; definition of, 151-52; division of, no; 113-16; effect of in- crease of, upon productivity, 100-01 ; government regulation of conditions of, 386-88; of children, 387; of women, 387-88 ; price of, 82 et seq. Labor, American Federation of, 181 ; 183. Labor organization, ch. XI ; effect upon wages, i88-go. Lais ser ~f air e^ 375-7^. Land, causes of rise in value, 231; price of use of, 81-82. Large scale production, 126 et seq. Legal tender, 260-61. Life insurance company, 320-21. Loans, bank, 290; call, 285; disguised under form of sale, 282-83; producers' and consumers', 281-82. Marginal productivity, as determining wages, 156-57 ; of capital, 201-04. Marginal utility, 42. Market price, 36 et seq. Money, ch. XV ; affected by use of sub- stitutes, 266-67; changes in value of, 271-72; definition of, 253; functions of, 255-56 ; in international trade, 352- 54; increase of, effects of, 269-71; metallic, stability of value of, 277; necessary qualities of, 256-58 ; need of government regulation of, 257-58 ; origin of, 254-55 I paper, 266 ; 274-77 ; private coinage of, 258 ; value of, 262- 68; 300; standard, 259-60. Monometallism, 259. Monopoly, 16; 43; 76; affected by fear of competition, 65-66 ; created by law, 61 ; created by private agreements, 61- 62; definition of, 61; discriminations in charges, 71-76; government regula- tion of, 384-86; methods of destroy- ing competitors, 64-65 ; municipal, 395- Monopoly price, ch. IV; as affected by regard for the future, 69-71 ; limits upon, 75-76 ; theory of, 66 et seq. Monopoly profits, 246^52. Mortgage, 284 ; 306. Natural agents, 197; value of, affected by increase of capital, 207-08. Natural resources, conservation of, 367- 68. Negotiable paper, 284. Notes, bank, 297-300. Occupations, differentiation of, 107. Opportunity, 233 etseq. ; dependent upon economic changes, 236; dependent upon lack of competition, 237-38. Organization of labor, ch. XI ; relation to strikes and boycotts, 183-84. Paper money, 266 ; 274-77. Parity, maintained by redemption, 260- 61. Patents, 246-49. Paternalism, 375. Picketing, 182. Pool, 141-43. Population, density of, as related to economic differentiation, 111-12; in- crease of, effect on rent, 227-28 ; effect on wages, 159-60. Price, abnormal, 53-54 ; affected by changes in quantity of money, 263-69 ; affected by combinations, 50-51 ; affected by credit, 266-67 I affected by improvements in transportation, 44-45 ; affected by seasons, 52-53 ; changes of, effect on ground rent, 225-27 ; con- trolled through consolidation, 149; definition of, 35-36 ; effect of rise upon wages, 269-70; fluctuations in, 43 et seq.; government regulation of, 385; importance of, 18-20; influenced by ground rent, 86-87; market, 36 etseq.; monopoly, ch. IV ; monopoly, dis- criminations in, 73-76 ; monopoly, Hmitsupon, 75-76; normal, ^^^ etseq. ; normal, relation to cost of production, 48-49; 59; of finished products, 79-So; of labor, 82 et seq.; of materials of production, 78-79; of use of land, 8r- 82 ; rise of, effect on silver movement, 274. Producer's goods, 4. Production, 8-9; costof, ch.V; cost of, as determining normal value, 48-49; economy in, 101-03; large scale, 126 et seq. ; stimulated by freedom of enter- prise, 376-77. INDEX 403 Profit, ch. XIV; 49; 378; as a transient form of income, 245-46 ; capitalization of, 248-49; causes of, 238 etseq.; defi- nition of, 238 ; economic function of, 249-50; exploitation, 240-43; general, 244 ; monopoly, 246-52. Protection, as creating vested interests, 366 ; as a means of conserving natural resources, 367-68 ; as a means of in- suring national independence, 369-71 ; as a part of a policy of population, 368-69 ; effect upon wages, 357-61 ; for retaliation, 371-73; of infant industries, 363-65; to non-self-supporting indus- tries, 365-66; universal, 356-57. Public debts, origin of, 304-05. Railways, combinations among, 138 ; dis- criminations, 74-75; 131-32; national- ization of, 394-95. Redemption, 260-61. Regulation, governmental, conditions requiring, 381 etseq. Rent, ch. XIIT; affected by increase of population, 227-28; affected by price changes, 225-27; as affecting price, 86-87; 3-S a residue, 218-21 ; definition of, 215-16 ; gross and net, 217-18 ; net, equivalent to interest, 218 ; of land, dependent on wages and interest, 222-25; relation to cost of capital goods, 221-22, Reserves, bank, 294-95. Retaliation, 371-73. Revenue, from government enterprise, 392-93- Revenue duties, 353-54. Risk, as affecting productivity, 211-13; 309-10; as affecting wages, 165-69 ; to bank deposits, 296-97; relation to enterprise, 236-37. Saving, as origin of capital, 197-99. Savings bank, 317-19. Sellers, marginal, 40-41. Services, as a form of wealth, 4-5. Silver movement, 272-74. Smith, Adam, 10. Socialism, 375; 392. Specialization, 312-15. Standard of living, 2-3; effect upon wages, 169-71. Stock exchange, 312. Stocks, 306-07, Strike, 181-84. Supply, definition of, 39. Supply and demand, 39 et seq. ; 42 ; in relation to price of exchange, 339 et seq. Syndicate, underwriting, 315-16. Tariff, 350 ; 375. Taxation direct and indirect, 350-52 ; of foreign trade, 349-52, Tenancy, government regulation of, 390- 91. Trade, classification of, 326-27 ; condi- tions determining, 324-26; foreign, taxation of, 349-52; international, ch. XVI 11; affected by improvements in transportation, 328-29 ; relation to cost of production, 334-37; dependent, upon relative advantages in produc- tion, 327-28 ; interregional, conditions determining, 325-26. Trade union, 174 et seq.; 387; alliances of, 178 et seq. ; insurance features of, 178; limitations upon membership, 176-78. Transferability, as affecting productive- ness of investments, 310, Transportation, diminishing returns in, 99-100; improvements in, effect upon prices, 44-45 ; upon economic differ- entiation, 110-12; upon concentration, 123-24; upon international trade, 328-29. Trust, 143. Underwriting syndicate, 315-16. Unemployment, relation to division of labor, 118. Unfair list, 183. Usefulness, distinguished firom utility, 24-25. Utility, 42 ; definition of, 23-25 ; effective, 27-29; final, 26-27; Is-w of diminish- ing, 24-25 ; marginal, 26-27. Value, as the common property of wealth, 6-7 ; normal, determined by marginal cost, 55-59 ; personal, 29 et seq. Vested interests, created by protection, 366. 404 INDEX Wages, ch. X; 2>2 et seq.; affected by collective bargaining, 173-74; t>y di- minishing returns, 154; 161-62; by improvements in production, 160- 61 ; by increase of capital, 204 et seq. ; by increase in supply of labor, 159-60 ; by increased efficiency of labor, 159; by labor organizations, 188-90; by protection, 357-61 ; by risk, 165-69; by standard of living, 169-71 ; compet- itive, 154-55 1 definition of, 152-53 ; determined by marginal productivity, 156-59; diiferences in, 164 et seq.; effect of fall in, upon ground rent, 222-25 ; government regulation of, 388-89 ; inequalities in, 379 ; local va- riations in, 84-86; relation to foreign trade, 336-37. Wants, 21-22; elasticity of, 22-23 ; future, 6; law of, 25. Wealth, i; 4-5; consumption, produc- tion and distribution of, 8-9 ; concen- tration of, 124-25. Women's labor, 387-88.