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ELEMENTARY PRINCIPLES OF ECONOMICS • Ine Oe THE MACMILLAN COMPANY new York - Boston - CHICAGO Dallas - san Francisco MACMILLAN & CO., LIMITED London - Bombay - calcutta Melbourne THE MACMILLAN CO. OF CANADA, LTD. Toronto ELEMENTARY PRINCIPLES OF ECONOMICS : By }. IRVING FISHER PROFESSOR OF POLITICAL ECONOMY YALE UNIVERSITY Meto gork THE MACMILLAN COMPANY 1913 * All rights reserved CopyRIGHT, 1910, 1911, 1912, By THE MACMILLAN COMPANY. Set up and electrotyped. January, 1913. Published July, 1912. Reprinted - - - - - * - - - - - - - - - * - - - -- - - - - - - w - - *- - - - ** - - - - - -- *- * * - * ~ - - - - - * - - - - - - - - - .* - ". - - - - - * - - - - - - - -- - - - - Nortgcob 33regg J. S. Cushing Co. — Berwick & Smith Co. Norwood, Mass., U.S.A. (Co THE MEMORY OF MY FRIEND AND COLLEAGUE PROFESSOR LESTER W. ZARTMAN - - - - - - - - ~~~- - - - - - – — ) --- » _, _~~~~ * – ~~~~ ~~~~ º) PREFACE FOR TEACHERS THE words “Elementary Principles” in the title of this book indicate the limits of its scope; the book is intended to be elementary, not advanced, and concerns itself with economic principles, not their applications. First, being elementary, it does not attempt to unravel the most difficult tangles of economic theory or to intro duce controversial matter. For such studies it should be succeeded by more extensive treatises (e.g., my own: Nature of Capital and Income, Mathematical Investigations in the Theory of Value and Prices, Purchasing Power of Money, and Rate of Interest, which follow out the same general system of thought and exposition as adopted in this book). Secondly, being devoted to principles, the book is con fined to that part or aspect of economics which is now coming to be recognized as capable of scientific treatment in the sense, for instance, in which that term may be ap plied to physics or biology. The fundamental distinction of a scientific principle is that it is always conditional ; its form of statement is : If A is true, then B is true. A prin ciple differs in this respect from a fact which asserts unconditionally that B is true. Science is primarily con cerned with the formulation of principles. The aim of this book is to formulate some of the fundamental principles relating to economics. The method and order of treatment are not altogether traditional. The time-honored order of topics — produc tion, exchange, distribution, consumption – has been found vii viii impracticable. PREFACE Such an order was probably originally in tended to parallel the natural course of events from the production of an article to its consumption ; but to-day these four topics scarcely retain any traces of such a parallelism. “Distribution,” for instance, has, in theo retical discussions, long ceased to be a description of the processes by which food, clothing, and other goods are distributed after being produced and prior to being con sumed, and has become simply a study of the determi nation of rent, interest, and other market magnitudes. It is not, therefore, surprising that many other textbooks on economics have also broken away from this unfortunate order of topics. Of the many possible methods of writing economic text books, there are three which follow well-defined, though widely different, orders of topics. These are the “his torical,” the “logical,” and the “pedagogical.” The his torical method follows the order provided by economic history; the logical begins with a classification of economics in relation to other studies, explains its methodology, and then proceeds by means of abstract examples from the simplest imaginary case of “Robinson Crusoe economics” to the more complex conditions of real life; the pedagog ical begins with the student's existing experience, theories, and prejudices as to economic topics, and proceeds to mold them into a correct and self-consistent whole. The order of the first method, therefore, is from ancient to modern ; that of the second, from simple to complex ; and that of the third, from familiar to unfamiliar. The third order is the one here adopted. That the proper method of study ing geography is to begin with the locality where the pupil lives is now well recognized. Without such a beginning the effect on the student’s mind may be like that betrayed by the schoolgirl, who, after a year's study of geography, was surprised to learn that her own playground was a part of the surface of the earth. In like manner we cannot ix PREFACE expect to teach economics successfully unless we begin with the material already existing in the student's mind. Those textbooks which open with a discussion of the rela tions of economics to anthropology, Sociology, jurispru dence, natural science, and biology, overlook the fact that the beginner in economics is totally unprepared even to understand the meaning of these great subjects, much less their relations to one another. The same sort of error is made by those textbooks which begin with a comparative study of the logical machinery by which truth is ground out in economics and in other sciences. The student's logical faculty must be exercised before it can profitably be analyzed. This book, therefore, aims to take due account of those ideas with which the student’s mind is already furnished, and to build on and transform these ideas in a manner adapted to the mind containing them. This is especially needful where the ideas are apt to be fallacious. The eco nomic ideas most familiar to those first approaching the study of economics concern money, -personal pocket money and bank accounts, household expenses and in come, the fortunes of the rich. Moreover, these ideas are largely fallacious. Therefore, the subject of money is introduced early in the book and recurred to continually as each new branch of the study is unfolded. For the same reason considerable attention is given to cash ac counting, and to those fundamental but neglected princi ples of economics which underlie accounting in general. Every student at first is a natural “mercantilist,” and every teacher has to cope eventually with the prejudices and misconceptions which result from this fact. Yet no textbook has apparently attempted to meet these difficul ties at the point where they are first encountered, which is at the beginning. It may be worth while to distinguish the pedagogical procedure here proposed from that recently advocated x PREFACE under the somewhat infelicitous title of the “Inductive Method.” I refer to the method by which the student is at first to be taught economic facts without any formula tion of principles. This proposal seems to assume that the student’s mind is quite a blank to start with, and that it is possible on this tabula rasa to inscribe facts without at the same time intimating how they are related. The truth is, however, that the student's mind is already familiar with a great mass of economic facts acquired at home, on the street, and from the newspapers. He knows some thing, not only of money and accounts, but of banks, rail ways, retail trade, labor unions, trusts, the stock market, speculation, the tariff, poverty, wealth, and innumerable other topics. It is equally true that his head is full of theories as to the relations of these facts, – the working of supply and demand, the nature of money, the operation of a protective tariff, etc. The difficulty is that most of his theories and many of his supposed facts are false; and before we add to his ill-assorted collection of mental furni ture we must arrange in orderly fashion that which he already possesses. Moreover, it is almost impossible to impart successfully any considerable mass of disconnected facts. If the teacher does not indicate the true connec tions, the student will almost inevitably supply false ones; º or else the facts without connections will be also without interest. These objections to the so-called “inductive method” are not, however, intended as militating against the object which its advocates strive to attain, viz., to make the stu º iº t s dent think for himself, nor against the chief means by which they actually attain this object, viz., the use of original problems. Every teacher can and should illus trate, emphasize, and elaborate every step in the study of º principles by propounding problems. Sumner's collection of problems, or the more recent collections of Taylor or of the University of Chicago, may profitably be used to sup l, t & PREFACE xi plement those which every good teacher will readily invent for himself from the suggestions of the text, of current newspapers, or of students’ questions. These should vary from year to year according to current events and the exigencies of the case as understood by the teacher. A pamphlet of suggestions as to problems to be used in connection with this book has been prepared for teachers and may be obtained of the publishers. It is submitted that the present treatment of the subject lends itself pecul iarly to the use of definite soluble problems in place of the vague “problems” which are usually employed in economics and which call for little more than an expression of opinion. Incidentally, the teacher will find that these definite arithmetical problems are not only much more useful to the student, but are much less trouble for the instructor to correct and grade. Problems should, I believe, supplement and not supplant a textbook. The effort to substitute problems for textbooks has always failed even in those subjects which, like algebra and geometry, may be said to consist naturally of a series of problems. A preliminary framework of general prin ciples is needed in order to formulate special problems of real value. Problems which are really soluble by the beginner can be little more than applications of general principles to special cases. What has been said will help explain why greater atten tion than usual is here paid to certain themes, such as money, bank deposits, accounting, the rate of interest, and the personal distribution of wealth ; as well as why less attention than usual is paid to certain other themes, such as methodology and those obsolete theories like the “wage fund” theory which (unlike some other obsolete theories) has probably never formed any part of the student's mental stock in trade. To some critics the abundant use of curves may seem too advanced for an elementary work. But their use is xii PREFACE now so common in the advanced treatises to which the student is, if possible, to be led, that their introduction here is but a necessary part of his preparation. The very fact that there is at present no elementary book in which the nature and use of the graphic method has been made clear for the elementary student is a strong argument for its adoption. Moreover, I am persuaded that the “diffi culties” in the elementary use of curves are largely imagi nary. Every beginner in economics may be assumed to be familiar with latitude and longitude on a map, and perhaps also with the temperature charts in the daily paper. It is a very easy step from these to curves of supply and de mand, provided they be used with sufficient frequency and with sufficient system to take lodgment in the student's memory. The student who sees but one diagram in a book will find the initial effort of understanding that diagram scarcely worth while, – not much more worth while than to be taught the use of logarithms without applying them to more than one or two practical examples. As a matter of fact, there are few things which so facilitate the under standing of economic relations at every stage of economic study as the use of diagrams; and it is believed that, with them, the elementary student can proceed both faster and further in economic analysis than without them. Some friends are inclined to criticize the book as being too cold an analysis. They point out that the student's main interest in the subject is a “human interest” and concerned primarily with the practical and immediate solution of great public problems. No one acquainted with my interest in some of these problems can accuse me of lack of appreciation of the “human” element in them all. But the more one studies these problems and the attempts at their solution, the more evident it becomes that most students approach them with an insufficient grounding in fundamental principles. In social as in medical therapeu tics a lack of knowledge of anatomy and physiology results in PREFACE xiii quackery — in remedies worse than the disease which it is proposed to treat. I believe that one of the greatest needs to-day in the teaching of elementary economics is to curb this popular tendency to run after remedies before formulating principles. Un the present book, therefore, while most of the great practical problems of economics are outlined in connection with the principles which must be employed in their solution, the solutions themselves are not discussed. Full discussion of all these problems is impossible in any textbook, and I earnestly deprecate a general ex cathedra pronouncement of personal opinion by an author on moot questions, especially in a book for imma ture students. The only proper course, in my opinion, is for the student first to master the fundamental economic principles on which all or most competent economists can agree, and then, as suggested on the closing page of this book, to take up some one moot question — some burning issue of the day — and, so far as possible, master that also. In the meantime he should, so far as possible, keep an open mind on other problems until, in course of time, they may also be taken up intensively, one by one. A textbook which attempts to supply the student with ready-made opinions on all practical problems “while he waits,” may be supplying a real demand, but is not performing a high service. Possibly the slight emphasis here put on historical, de scriptive, and practical economics may decide some teachers against the use of this book and lead them to choose a book in which “the whole subject of economics” is treated. I submit, however, that no such “complete” book exists, since no author exists capable of writing it, and that all which aim to be complete lack at least half of the subject matter here presented and which is taken for granted as if fully known by the student. In many books the terms “assets,” “liabilities,” “income,” “cost,” and “rapidity of circulation” are used without discussion or even definition. xiv. PREFACE It would be out of place here to criticize other textbooks, but it has been my hope that the present book may be found a useful introduction to other books, even those which attempt to cover the subject “completely.” I would also point out that, by omitting the more “therapeutical” parts of the subject, I have escaped most of its controversies, for the controversies to-day are more as to the solution of practical problems than as to the validity of such elementary principles as are contained in this book. Freedom is thus allowed to each teacher who uses this textbook to follow it up by whichever among others contains the therapeutical treatment which he personally regards as correct. I have been struck by the fact that my critics seldom question the correctness of the propositions here laid down. If this book may afford a common starting point for economic instruction of different schools of thought and different attitudes toward public problems, it will have served one important purpose. Especial care has been taken in formulating definitions so that the concepts described by these definitions may become firmly fixed in the students' minds. These defini tions and concepts have been chosen in reference to their usefulness in economic analysis as well as their conformity to practical usage. I am one of those who believe that when the usage of academic economics conflicts with the ordinary usage of business, the latter is generally the better guide. This is not only because business usage has a thousand times the currency of academic usage, but also because in general it comes closer to the needs of economic analysis. Here is not the place to argue why this is true, or even to prove that it is true. I will, however, mention one consideration which appeals increasingly to practical teachers: An academic tradition which is unconvincing to the student is sure later, when he himself becomes a business man and perceives how badly academic traditions are out of tune with modern business usage, to breed a deep distrust, PREFACE XV if not contempt, for all academic economics. Thus, expedi ency, as well as sound theory, should urge teachers to respect the usage of business men. I have taken so much space to justify those features of this book which will seem new, because several teachers to whom the experimental editions were submitted have condemned it at sight as unteachable. I am glad to re port, however, that the teachers who have actually tested the book in classroom have usually become extremely enthusiastic over its “teachableness,” although many of them had begun its use with grave misgivings. The experimental editions, of which there were two, were made possible by special arrangement with the pub lishers. This gave opportunity for thorough trial for two years in classrooms at Yale, under nearly a dozen different instructors. As a result of this trial and the many valuable suggestions and criticisms which were obtained from teachers, students, and friends, the book has been virtually written three times. The present — the third and final — edition is the first to be offered to the general public. I am under obligations to President Hadley of Yale for the fundamental idea employed in the discussion of those supply curves which illustrate the willingness to produce “a given amount or more” instead of, as ordinarily assumed, “a given amount or less”; also for helpful criticism on the presentation of that most difficult subject, the rate of interest. I am also indebted for helpful criticism to my colleagues, Professor Clive Day, Assistant Professors F. R. Fairchild, H. P. Fairchild, W. H. Price, and A. L. Bishop, Dr. H. G. Brown, Dr. E. J. Clapp, now in New York Univer sity, and Dr. J. L. Leonard; also to Professor Charles W. Mixter of the University of Vermont, Professor Harvey A. Wooster of De Pauw University, Professor Louis N. Robin son of Swarthmore College, Dean David Kinley of the University of Illinois, Professor E. W. Kemmerer of Cornell University, Professor H. J. Davenport of the University xvi PREFACE of Missouri, Professors E. R. A. Seligman, H. R. Seager, and H. R. Mussey of Columbia University, R. T. Ely and W. A. Scott of Wisconsin University, and W. M. Adriance of Princeton University, Mr. W. F. Hickernell, now with the Brookmire Economic Chart Company of St. Louis, Mr. Morrell W. Gaines of the Statistical Department of Brown Brothers and Company of New York, Mr. Julius H. Parmelee, statistician of the Bureau of Railway Economics, Washington, D.C., Professor E. B. Wilson of the Massa chusetts Institute of Technology, Dr. Leonard Bacon of New Haven, and to Mr. J. M. Shortliffe of the Graduate Department of Yale University. I endeavored to obtain a clear idea of the undergraduates' viewpoint by offering prizes for the best criticisms from students using the book as a textbook, the prizes being awarded by a committee of instructors other than myself. In the college year 1910–1911, the students who won the prizes were R. H. Gabriel, 1913, E. J. Webster, 1913, and G. G. Chandler, 1912, and in the year 1911–1912, Edward Glick, 1914, W. Van B. Hart, 1914, and M. W. Brush, 1913. The criticisms of others besides the prize winners were found helpful. To H. Briar Scott, 1913, I am also indebted for suggesting the insertion of Figure 2. My greatest obligations for criticism, especially as to the mode of pres entation, are due to my brother, Herbert W. Fisher, who has kindly read and criticized all of the original manuscript and both preliminary editions. - MAY, 1912. IRWING FISHER. º | SUMMARY FouxDATION STONES Introduction - - - - - Capital - - - - - - Income - - - - - - . - - - Capital and Income Chapters I–II Chapter III Chapters IV-V Chapters VI–VII DETERMINATION OF PRICES . - - - - Particular Prices. - - - - Rate of Interest . - - - - . - - c Ownership of Income . - - - General Prices Chapters VIII-XIV Chapters XV-XVIII Chapters XIX-XXII PRINCIPLES OF DISTRIBUTION Sources of Income Chapters XXIII-XXIV Chapters XXV-XXVI CONTENTS BY CHAPTERS charrºr I. II. pace WEALTH . - - - - - - - - PROPERTY . - - - - - - - • I 23 III. CAPITAL . - - - - - - - • 37 IV. INCOME - - - - - - - - . 60 COMBINING INCOME ACCOUNTS . - - - • 75 CAPITALIZING INCOME. - - - - ... I O2 VII. VARIATIONs of INCOME IN RELATION to CAPITAL . 127 L-VIII. PRINCIPLES GOVERNING THE PURCHASING Power OF V. VI. MONEY IX. X. . - - - - - INFLUENCE OF DEPOSIT CURRENCY XII. XIII. L-XIV. XV. XVI. XVII. XVIII. XIX. XX. XXI. - - • I44 - - . 165 CAUSES AND EFFECTS OF PURCHASING POWER DUR ING TRANSITION PERIODS XI. - . . REMOTE INFLUENCES ON PRICES REMOTE INFLUENCES (Continued) - - - . 184 - - - . I 92 . - - . 204 OPERATION OF MONETARY SYSTEMS . - - . 22 I 24O CONCLUSIONS ON MONEY . - - - - • SUPPLY AND DEMAND . . . . . . 258 THE INFLUENCES BEHIND DEMAND . - - . THE INFLUENCES BEHIND SUPPLY . - - . 303 MUTUALLY RELATED PRICES . - - - • 333 INTEREST AND MONEY - - - - • 354 IMPATIENCE For INCOME THE BASIs of INTEREST . 365 INFLUENCES ON IMPATIENCE FOR INCOME . • 375 - - XXII. THE DETERMINATION of THE RATE of INTEREST 278 . 389 INCOME FROM CAPITAL - - - - - . 4 IO XXIV. INCOME FROM LABOR . - - - - - • 433 XXV. WEALTH AND POWERTY - - - - - • 464 XXVI. WEALTH AND WELFARE . - - - - • 494 XXIII. CONTENTS BY SECTIONS CHAPTER I WEALTH section race Definition of Economics and of Wealth - - - - Distinction between Money and Wealth - - - - Classification of Wealth i Measurement of Wealth Price . Value I 5 9 - - - - - - - - - - - - - • II - - I3 17 - - - - - - - - - - - - - - - - • . Limit of Accuracy in Economic Measurements . - • 20 • • 23 25 . CHAPTER II PROPERTY . The Benefits of Wealth . The Costs of Wealth . - - - - - e - - - - - - Property, the Right to Benefits . The Relation between Wealth and Property . Table of Typical Property Rights . Practical Problems of Property . - i - - - . 26 - - • 30 • • 33 34 - - - - - - - - CHAPTER III CAPITAL 1. 2. 3. 4. 5. Capital and Income Capital-goods, Capital-value, Capital-balance . Book and Market Values Case of decreasing Capital-balance. Insolvency . - - - - - - 6. Real and Fictitious Persons - - - - - • 37 - - • 39 - o - - • 44 - - - - • 45 48 - - - - - - . . - - - - - . So - - . 5I 7. Two Methods of Combining Capital Accounts 8. Ultimate Result of Method of Couples . 9- Confusions to be Avoided . - xxi - - - - • 54 - - - • 57 xxii CONTENTS BY SECTIONS CHAPTER IV INCOME seCTION I. PAGE Concepts of Income and Outgo . - - - - - Income Accounts. - - - - - - . - - - - - Devices for Making Net Income Regular : How to Credit and Debit . 64 - - - - - - Omissions and Errors in Practice. - - - - - 72 . 75 77 CHAPTER V COMBINING INCOME ACCOUNTS 1. Methods of “Balances” and “Couples.” “Interactions” Production: Interactions which change the Form of Wealth Transportation: Interactions which change the Position of Wealth 4. - - - - - Wealth - - . - - - - - - 8I - Accounts Illustrative of Interactions in Production 85 Preliminary Results of Combining these Income Accounts Analogies with Capital Accounting . Double Entry in Accounts of Fictitious Persons . Double Entry in Accounts of Real Persons . 88 - i - Exchange: Interactions which change the Ownership of - - º - Ultimate Costs and Income . - - 95 - - - - - - - - - - - - - - - - - - - - CHAPTER VI CAPITALIZING INCOME The Link between Capital and Income Capital as Discounted Income i The Discount Curve . Io2 . - - Application to Valuing Instruments and Property Effect of Changing the Rate of Interest - IoW Io8 II 2 - 125 CHAPTER VII VARIATIONS OF INCOME IN RELATION TO CAPITAL Interest Accrued and Income Taken Out . - Illustrations . - - - - - - - 127 - I29 CONTENTS xxiii BY SECTIONS sECTION PAGE 3. Confusions to be Avoided 4. Standardizing Income . 5 The Risk Element. 6. Review . - - . . . - - - - - - . I 32 136 138 - - I40 - CHAPTER VIII PRINCIPLES Governing THE PURCHASING Power OF MONEY i Introductory . The Nature of Money The Equation of Exchange Arithmetically Expressed The Equation of Exchange Mechanically Expressed The Equation of Exchange Algebraically Expressed The “Quantity Theory of Money” I44 I47 15I I 56 I 59 16o CHAPTER IX INFLUENCE OF DEPOSIT CURRENCY The Mystery of Circulating Credit. The Basis of Circulating Credit . Banking Limitations . The Total Currency and its Circulation . Deposit Currency Normally Proportional to Money - - ; - - 165 - 171 I74 - 178 - Summary - - 18O 183 - CHAPTER X CAUSES AND EFFECTS OF PURCHASING POWER DURING TRANSITION PERIODS Transition Periods : - - - - . 184 How a Rise of Prices Generates a Further Rise How a Rise of Prices Culminates in a Crisis . 187 Completion of the Credit Cycle 189 . - - I86 CHAPTER XI REMOTE INFLUENCES ON PRICES 1. Influences which Conditions of Production and Consumption Exert on Trade, and therefore on Prices . 192 xxiv. CONTENTS BY SECTIONS SECTION PAGE 2. Influences which Conditions Connecting Producers and Con sumers Exert on Trade, and therefore on Prices - - I94 3. Influence of Individual Habits on Velocities of Circulation, and therefore on Prices . - - - * * - - - 196 4. Influence of Systems of Payments on Velocities of Circulation, and therefore on Prices - - - - - - I99 5. Influence of General Causes on Velocities of Circulation, and therefore on Prices - - - - - - 2O I 6. Influences on the Volume of Deposit Currency, and therefore on Prices . - - - - - - - - - 2O2 CHAPTER XII REMOTE INFLUENCES (Continued) 1. Influence of “The Balance of Trade” on the Quantity of Money, and therefore on Prices 2. Influence of Melting and Minting on the Quantity of Money, and therefore on Prices - - - - - - - - - - - 3. Influence of the Production and Consumption of Money Metals on the Quantity of Money, and therefore on Prices 4. Mechanical Illustration of these Influences . - CHAPTER XIII 2O4 209 2II - - 215 g 22 I t OPERATION OF MONETARY SYSTEMS I. Gresham's Law . - - - - - - - 2. Bimetallism - - - - - - - - 3. 4. 5. 6. . When Bimetallism Fails When Bimetallism Succeeds . Changes in Production and Consumption The “Limping” Standard . - 223 226 - - - - - - - - - - - - - - - - - - - - - - 230 233 235 * -- CHAPTER XIV CONCLUSIONS ON MONEY 1. 2. 3. 4. Can “Other Things Remain Equal?” . An Increase of Money does not Decrease its Velocity An Index Number of Prices . The History of Price Levels . - - - - - - - - - - - - 24o 242 247 253 CONTENTS BY SECTIONS CHAPTER XV SUPPLY AND DEMAND SECTIox 1. 2. 3. 4. 5. PAGE Individual Prices Presuppose a Price Level A Market and Competition . Demand and Supply Schedules . Demand and Supply Curves . Shifting of Demand or Supply - - . • - - - - 258 26o 261 - - - - - - - - - - - - - 263 268 CHAPTER XVI THE INFLUENCES BEHIND DEMAND 1. Individual Demand Schedules and Curves 2. 3. 4. 5. 6. 7. 8. . - - Desirability . Illustration . Some Remarks on Desirability . Individual Demands Derived from Marginal Desirabilities Relation of Market Price to Desirability. Importance of the Marginal Desirability of Money. Desires or Wants, the Foundation of Demand - - - - - - - - - - - - - - - - - - - 278 28 I 283 286 - - 287 294 298 3oo CHAPTER XVII THE INFLUENCES BEHIND SUPPLY I - Analogies between Supply and Demand Principle of Marginal Cost . Upward Supply Curves which Turn Back Downward Supply Curves . Resulting Cutthroat Competition Resulting Tendency toward Monopoly . Fixed and Running Costs . General and Particular Running Costs . - - - - - - Monopoly Price . . - - - - - - - 303 - - - 307 312 3I4 - - - - - 317 - - - 32 I - - - 323 - - - 326 - - - 329 - - 338 CHAPTER XVIII MUTUALLY RELATED PRICES Arbitrage . - - - - - - Speculation . - - - - - - 333 XXVI CONTENTS BY SECTIONS section PAGE 3. Prices of Goods which Compete on the Demand Side . • 344 4. Prices of Goods which are Complementary on the Demand Side 347 5. Similar Relations on the Supply Side . - 348 6. Prices of Goods in Series - - - • - - - - - • 350 - - • 35 I 354 7. Efforts and Satisfactions the Ultimate Factors CHAPTER XIX INTEREST AND MONEY 1. 2. 3. 4. The Importance of Interest . A Common Money Fallacy . Effect during Appreciation or Depreciation Effect of Unequal Foresight . - - - - - • - - - - - . 356 - - . - - • 359 - - - . 362 CHAPTER XX IMPATIENCE FOR INCOME THE BASIS OF INTEREST 1. The Productivity Theory 2. The Socialist Theory . 3. Impatience the Source of Interest . - - - - - - . 365 - - - - - - . 369 - - - - • 37 I CHAPTER XXI INFLUENCES ON IMPATIENCE FOR INCOME 1. Differences in Impatience Due to Differences in Human Nature 375 2. Differences in Impatience Due to Differences in Income. . 378 3. Influence of the Distribution in Time of the Income-stream . 379 4. Influence of the Size of the Income-stream 5. Influence of Uncertainties of Income 6. Summary . - - - - . - - . - - - - - - - . . . 381 383 386 CHAPTER XXII THE DETERMINATION OF THE RATE OF INTEREST 1. Equalizing Marginal Rates of Impatience by Borrowing and Lending . 389 2. Equalizing Marginal Rates of Impatience by Spending and Investing . • 394 - - - - - - - - - - - - - - - - - CONTENTS BY xxvii SECTIONS section PAGE 3. Futility of Prohibiting Interest . 4. Clearing the Loan Market . 5. The Conditions Determining the Rate of Interest . - 6. Historical Illustrations 7. Interest and Prices - - - - - 396 - - - - - 398 . - - - . . . . . . - - - 8. Classification of Price Influences - 4OO - - 4O4 . . . - - 406 408 - CHAPTER XXIII INCOME FROM CAPITAL Distribution according to Agents of Production and according to Owners 4 Io 2. The Rent of Land . 413 3. Rent and Interest . - - - - - - - 4. Four Forms of Income: Interest, Rent, Dividends, and Profits 5. Avoidance of Risk. - - - - 422 - - - - 423 427 CHAPTER XXIV INCOME FROM LABOR 1. 2. 3. 4. 5. 6. 7. Similarity of Rent and Wages Peculiarities of Labor Supply. The Demand for Labor . The Efficiency of Labor. The “Make-work” Fallacy . Wages and Enterprisers' Profits . Profits and Distribution Generally. - - - - - - - - 433 - - - - - - 436 - - - e - - - - - - - - - - - - - - - - - - 45 I 454 - - - - - 458 . - - - - - - - - - - - - 469 - - - - - 472 - - - - . - - CHAPTER XXV WEALTH AND POVERTY . The Problems of Wealth and Poverty National Wealth or Poverty . i - . Per Capita Wealth or Poverty . Population in Relation to Wealth . - . Distribution of Wealth . - - 6. Fauality of Distribution an Unstable Condition 7. The Limits of Enrichment and Impoverishment 464 467 476 478 483 xxviii CONTENTS BY SECTIONS section PAGE 8. The Cycle of Wealth . 9. The Actual State of Distribution . Io. The Inheritance of Property - - - - - - - 487 489 - - 49 I CHAPTER XXVI WEALTH AND WELFARE True and Market Worth - - - Evils Connected with the Quantity of Wealth Forms of Wealth Injurious to the Owner Forms of Wealth Injurious to Society . - Forms of Wealth used for Social Rivalr The Cost of Vanity . Remedies for the Evils of Vanity. Recapitulation . - - - - - - 494 495 498 499 500 - - - - 508 - e 5II ELEMENTARY PRINCIPLES OF ECONOMICS CHAPTER I WEALTH § 1. Definition of Economics and of Wealth ECONOMICs may be most simply defined as the Science of Wealth. It is also known under several other titles, of which the most common is “Political Economy.” The P purpose of economics is to treat the nature of wealth; the human wants served by wealth; the satisfaction of those wants and the efforts required to satisfy them; the forms of the ownership of wealth; the modes of its accumulation and dissipation; the reasons that some people have so much of it and others so little; and the principles that regu late its exchange and the prices which result from exchange. , In a word, everything which concerns wealth in its general sense comes within the scope of economics. It is worth emphasizing at the outset, that the chief purpose of eco nomics is to set forth the relations of wealth to human life and welfare. It is not, however, within the province of economics to study all aspects of human life and welfare, but only such as are connected in some rather direct manner with wealth. To most persons the chief interest in the subject lies in its practical applications to public problems, such as those connected with the tariff, taxation, currency, trusts, trade unions, strikes, or socialism. These problems suggest that something is wrong in the present economic order of society and that there is a way to remedy it. But before we can treat of economic diseases, we must first understand the b I . . . . . ; ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I çconomic principles which these public questions involve. (hat is, the study of economic principles must precede the application of those principles to problems of public policy. ſ Tn the end the student will reach more satisfactory con clusions, if at the beginning he will put aside all thought of such applications, and cease to count himself a free trader or a protectionist, an individualist or a socialist, or, indeed, any other kind of partisan. We must, then, in the first place, distinguish economic principles from their applications to public problems; in the second place, we must distinguish those principles from their applications to private problems. Economics does not concern itself with teaching men how to become rich; nor does a practical skill in the art of becoming rich imply, necessarily, a sound knowledge of economics. Economics, it is true, represents the theory of business; and business, the practice of economics. But, though they are not in the least conflicting — indeed, to some extent they are mutually helpful – economics and business are nevertheless totally different. The primary requisite of a good business man is to master the detailed facts which concern his own indi vidual operations; the primary requisite of a good economist G to master the general principles based on business facts. S ome of the wildest economic theories have originated among uccessful financiers. Men who have been trained in Wall Street are often the most sadly lacking in elementary in struction in economics. This is so because the very matters with which people have longest been familiar are frequently the ones which they have been least disposed to analyze. In business theory, no less than in the theory of public problems, men take too much for granted. Our first rule, then, in approaching the study of economics is to take nothing for granted. It is quite as important to be careful in defining familiar terms, such as “prices" and “wages,” as in explaining unfamiliar ones, such as “index numbers ” and “marginal utility.” Sec. 1] WEALTH 3 …” _* º º º The chief purpose of this book is to define clearly the fundamental concepts of economics and to state and prove the fundamental principles of the science. These concepts and principles will then serve as a basis for further study. In other books the student will find these concepts and prin ciples applied to problems of public policy, or of business management, or of the economic history of nations. We are not concerned in this book either with practical prob lems or economic history except as they are used occa sionally to illustrate the principles under consideration. Wealth having been designated as the subject matter of economics, the question at once arises: What is wealth? By wealth in its broader sense is meant material objects owned by human beings. This meaning, however, is broader than the ordinary meaning of the term; for it includes human beings themselves. Every human being is a “ma terial object” and is “owned ” either by another human being, as in the case of slavery, or by himself, if he is a freeman. But in ordinary usage men except themselves from the category of “wealth '' just as, with equal incon sistency, they except themselves from the category of “ani mals.” Properly speaking man is wealth, just as, properly speaking, man is an animal. But we so seldom need in practice to take account of man as wealth that the ordinary meaning of wealth includes only material objects owned by human beings and external to the owner." In this book we * Every writer may define a term as he pleases, except that he should justify his definition in one or both of two ways: (1) by showing that it accords with common practice; and (2) by showing that it leads to useful results. The above definition of wealth meets both of these requirements. It agrees substantially with the usual understanding of business men, and it is useful in the development of the science of economics. Some economists add to the definition that an object, to be wealth, must be useful. But utility is really implied in ownership. Unless a thing is thought to be useful, no one would care to own it. Nothing is owned which is not useful in the sense that its owner hopes to receive benefits from it, and it is only in this sense that utility is to be employed as a technical term in economics. Therefore, as utility is already implied in ownership, it 4 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I shall follow ordinary usage by employing this narrower meaning except occasionally when it will be found conven ient to refer to the broader meaning. Any particular article of wealth may be called an “instrument.” Thus a locomotive is an article of wealth or an instrument. Other examples are an automobile, a horse, a house, a lot, a chair, a book, a hat, a loaf of bread, a coin. In common parlance “wealth '' is often opposed to “poverty,’” the contrast being between a large amount of wealth and a small amount; precisely as in common par lance “heat" is opposed to “cold,” the contrast being between a large degree of heat and a small degree. But just as in physics ice is regarded as having some degree of heat, so in economics a poor man is regarded as having some degree of wealth. f Wealth, then, includes all those parts of the material | universe that have been appropriated to the uses of man kind." It includes the food we eat, the clothing we wear, the dwellings we inhabit, the merchandise we buy and sell, the tools, machinery, factories, ships, and railways, by which other wealth is manufactured and transported, the land on which we live and work, and the gold by which we buy and sell other wealth. It does not include the sun, moon, or stars, for no man owns them. It is confined to this little need not be mentioned separately in our definition. Other writers, while including in their definition the idea of utility, omit the idea of ownership and simply define wealth as “useful material objects.” But this definition includes too many “objects.” Rain, wind, clouds, the Gulf Stream, the heavenly bodies, especially the sun, from which we derive light, heat, and energy, are all useful and material, but are not appropriated, and so are not wealth as commonly understood. Even more objectionable are those defi nitions of wealth which omit the qualification that it must be material; they do this in order to include stocks, bonds, and other property rights, as well as human and other services. While it is true that property and services are inseparable from wealth, and wealth from them, yet they are not them selves wealth. To include wealth, property, and services all under “wealth,” involves a species of triple counting. A railway, a railway share, and a railway trip are not three separate items of wealth; they are respectively wealth, a title to that wealth, and a service of that wealth. SEc. 2) WEALTH 5 planet of ours, and only to certain parts of that; namely, the appropriated sections of its surface and the appropriated objects upon that surface. § 2. Distinction between Money and Wealth One of the first warnings needed by the beginner is to avoid the common confusion of wealth with money. Few persons, to be sure, are so naïve as to imagine that a million aire is one who has a million dollars of actual money stored away; but, because money is that particular kind of wealth in terms of which the value of all other kinds of wealth is meas ured, it is sometimes forgotten that not all wealth is money. We are not yet ready for an extended study of money, nor even for a definition of money, but as a warning we shall here enumerate a few of the most common fallacies which beset the subject. The nature of these fallacies the student will understand at a later stage. They are introduced here not with any idea that the student will at once see where the error lies, but chiefly for the purpose of ridding his mind of the ordinary unwarranted assumptions about money. First among these fallacies, is the assertion that if one man “makes money,” some one else must “lose ’’ it, since there is only a fixed stock of money in the world, and it seems clear that “whatever money the money-maker gets must come out of some one else's pocket.” The flaw in this reasoning is the assumption that gains in trade are simply gains in actual money, so that in every business transaction only one party can be the gainer. If this were true, we might as well substitute gambling for business and for manufacturing; for in gambling the number of dollars won is equal to the number of dollars lost. As a matter of fact, however, it is not in order to obtain money that people engage in trade, but in order to obtain what money will buy, and that is precisely what both parties to a normal transaction eventually do obtain. 6 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I Again, some persons have tried to prove that the people of the earth can never pay off their debts because these debts amount to more than the existing supply of money. “If we owe money,” it is argued, “we can't pay more money than there is.” This assertion sounds plausible, but a moment's thought will show that the same money can be, and in fact is, paid over and over again in discharge of several different debts; not to mention that some debts are paid without the use of money at all. A few years ago at a meeting of the American Economic Association a Western banker expressed the opinion that the total amount of money in the world ought to be equiva lent to the total wealth of the world; else, he suggested, people would never be able to pay their debts. He explained that in the United States there were twenty dollars of wealth for every dollar of money; and he inferred that therefore there was but one chance in twenty of a debtor's paying his debts. “I will give five dollars,” he said, “to any one who can disprove that statement.” When no one accepted the challenge, a wag suggested that it was because there was but one chance in twenty of getting the promised five dollars | - The attempt to equalize money and wealth by increasing money twenty fold would, as we shall see later, prove abso lutely futile. The moment we increased the amount of money, the money value of all other forms of wealth would rise, and there would, therefore, still be a discrepancy be tween the amount of money and the amount of wealth. A very persistent money fallacy is the notion that some times there is not enough money to do the world's business, and that unless at such times the quantity of money is increased, the wheels of business will either stop or slacken their pace. The fact is, however, that any quantity of money, whether large or small, will do the world's business as soon as the level of prices is properly adjusted to that quantity. In a recent article on this subject, an editor of a Sec. 2) WEALTH 7 popular magazine put this fallacy into the very title: “There is not enough money in the world to do the world's work.” He says, “The money is not coming out of the ground fast enough to meet the new conditions of life.” In reality, money is coming out of the ground faster than the “new conditions' require, with the consequent result of raising prices. A more subtle form of money fallacy is one which admits that money is not identical with wealth, but contends that money is an indispensable means of getting wealth. At a recent meeting of the American Economic Association a very intelligent gentleman asserted that the railways of this country could never have been built in the early fifties had it not been for the lucky discovery of gold in California in 1849, which provided the “means by which we could pay for the construction of the railways.” He overlooked the fact that the world does not get its wealth by buying it. One person may buy from another; but the world as a whole does not buy wealth, for the simple reason that there would be no one to buy it from. The world gets its railways, not by buying them, but by building them. What provides our railways is not the gold mines, but the iron mines. Even though there were not a single cent of money in the world, it would still be possible to have railways. The gold of California enriched those who discovered it, because it en abled them to buy wealth of others; but it did not provide the world with railways any more than Robinson Crusoe’s discovery of money in the ship provided him with food. If money could make the world rich, we should not need to wait for gold discoveries. We could make paper money. * This, in fact, has often been tried. The French people once thought they were going to get rich by having the govern ment print unlimited quantities of paper money. Austria, Italy, Argentina, Japan, as well as many other countries, including the American colonies, and the United States, have tried the same experiment with the same results — no * 8 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. I real increase in wealth, but simply an increase in the amount money to be exchanged for wealth. The idea that money is the essence of wealth was one of the ideas which gave rise to a set of doctrines and practices, called Colbertism or Mercantilism, the earliest so-called “school’ of political economy. Colbert was a distinguished minister under Louis XIV of France in the seventeenth century, and a firm believer in the theory that, in order to be wealthy, a nation must have an abundance of money. His theory became known as Mercantilism because it re garded trade between nations in the same light in which merchants look upon their business — each measuring his prosperity by the difference between the amount of money he expends and the amount he takes in. To keep money within the country, Colbert and the Mercantilists advo cated the policy now known as “protection.” To-day it is generally understood that, in trade between nations, as in that between individuals, both parties may gain in an exchange transaction; but the mercantilistic fal– lacy that a nation may get rich by selling more than it pur chases, and collecting the “favorable balance of trade ’’ in money, still forms one of the popular bases of protectionism in the United States. The more intelligent protectionists give quite different reasons for a protective tariff, but the old fallacious reason still appeals to the multitude. They continue to think that by putting up a high tariff so that people are prevented from spending money abroad and are compelled to keep it at home, the country will in some way be made richer. One reason for the persistence of this fallacy is the continued use of the misleading phrase “favor able balance of trade '' to indicate an excess of exports over imports and “unfavorable balance of trade '' to indicate the opposite condition. Money fallacies of the kinds we have described must be carefully avoided by the student. He should realize that no technical term, such as “money,” can be used as a basis . •. SEC. 3] WEALTH 9 of reasoning without a carefully formulated definition. All catch phrases should be avoided. Especially should the student be on his guard against every proposition concerning money. “Making money,” for instance, is a catch phrase used without any definition. Properly speaking, nobody can “make ’’ money except the man in the mint. The rest of us may gain wealth, but, unless we are counterfeiters, we cannot literally “make ’’ money. We live in a complicated civilization in which we talk in terms of money. Money has come to be a sort of veil which hides the other and more important wealth of the world. Our first task is to take off the veil and see the wealth under neath. We shall then see clearly that wealth can be accu mulated only as it is actually produced and saved. § 3. Classification of Wealth Various kinds of wealth may be distinguished. That kind of wealth which consists of portions of the earth's sur face is called land. ) Among examples of land are to be in cluded not o farms, city lots and streets, but mines, quarries, oyster beds, fisheries, waterways, etc. All waters which are owned are in economics called land, being a part of the surface of the earth. Fixed structures upon land are called land improvements. The chief examples of land im provements are houses and other buildings, fences, drains, railways, tramways, macadamized streets, etc. Land and land improvements taken together are called real estate, the word “real" signifying immovable. All wealth which is movable may conveniently be called commodities, although the usage for this term is not altogether certain. Among examples of commodities are wheat, pig iron, food, fuel, fur niture, jewelry, clothing, books, chairs, machinery, etc. The term “commodities" also includes slaves, so far as this particular species of wealth exists. It will be remembered, however, that the definition of IO ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I wealth which has been adopted excludes free human beings. It was in order to exclude free human beings from the cate gory of wealth that the phrase “external to the owner’’ was inserted in the definition. Slaves are wealth, for they are external to their owner; but freemen are not wealth in its narrower or ordinary meaning." There are, of course, many admissible ways of classifying wealth. That which follows is intended to exhibit the prin cipal groups into which wealth most naturally falls. It is advisable that the student construct other classifications for himself. | Land Real Estate - Land improve- Agricultural land Building land Ways of transit Buildings Improvements on highways mentS WEALTH Miscellaneous - Raw materials Commodities Mineral Agricultural Manufactured Finish inished products {{. Consumable * In the broader meaning of the term “wealth” all men, even freemen, are, as has been said, wealth. But they are wealth of a peculiar kind be cause they are not, like ordinary wealth, bought and sold and because the wealth owned and its owner are in this case, identical. It is difficult, how ever, to draw a strict line of distinction between slaves (human beings owned by other human beings) and freemen (human beings owned by them selves); for in some cases human beings are owned partly by others and partly by themselves; as, for instance, vassals, serfs, indentured servants, long-time apprentices, and men held in peonage. A man bound out to ser vice for thirty years is almost indistinguishable from a slave, and if his term of service be long enough, the distinction fades away completely. On the other hand, the shorter the term of service the nearer does his condition approach freedom. As a matter of fact, almost all workers in modern society are bound by contract to some extent and for some period of time, even though it be no more than an hour; and to that extent they are not free. In short, there are many degrees of freedom and many degrees of slavery, with no fixed line of demarcation. This is one reason why the broader meaning of “wealth” is often more useful than the narrower. SEc. 4) WEALTH II It scarcely needs to be stated that these groups are not always absolutely distinct. Like all classes of concrete things, they merge imperceptibly into one another. For this reason the classification is of importance only as it gives a bird’s-eye view of the subject matter of economics. § 4. Measurement of Wealth Having seen what wealth is and what it is not, and having classified it roughly, we shall next examine separately its two essential attributes, materiality and ownership, devoting the remainder of this chapter to the first of these. The materiality of wealth provides a basis for a physical measurement of the various articles of wealth. Wealth is of many kinds, and each kind has its own appropriate unit of measurement. Some kinds of wealth are measured by weight. This is true, for instance, of coal, iron, beef, and in fact of most “commodities.” Of units of weight, a great diversity has been handed down to us, such as the pound avoirdupois, the kilogram, etc. In England, besides the avoirdupois pound, and the Troy pound, there is the pound sterling, used for measuring gold coin. This is much smaller than any other pound, owing partly to the frequent debasements of coinage that have occurred, and partly to changes in the past from silver to gold money. In the United States a dollar of “standard gold" (gold which is Tº fine) is a unit of weight employed for measuring gold coin. It is equivalent to 25.8 grains, or to #5% of a pound avoirdupois, since there are 7ooo grains in a pound avoirdu pois. We can scarcely put too much emphasis on the fact that the pound sterling and the dollar are units of weight.. They should be understood as such before any attempt is made to understand them as units of “value.” For many articles it is not so convenient to measure by units of weight as by units of space, whether of volume, of area, or of length. Thus we have, for volume, milk meas I2 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I ured by the quart, wheat by the bushel, wood by the cord, and gas by the cubic foot. For areas, we have lumber measured by the square foot, and land by the acre. For length, we have rope, wire, ribbons, and cloth measured in feet and yards. Many articles are already in the form of more or less convenient units. In these cases the measure of their quantity is the number of such units. For instance, eggs or oranges are usually measured by their number, expressed in dozens. Similarly, sheets of writing paper are reckoned by the “quire,” pencils and screws by the “gross.” In such cases the article is said to be measured “by number.” But “number" is by no means peculiar to such cases. All measurement whatever implies an abstract number, as well as a concrete unit. The only peculiarity of so-called measure ment “by number * is that the unit, instead of being one which is applied from the outside, as by the yardstick, is one into which the things measured happen to be already conveniently divided. In measuring the quantity of any particular kind of wealth it is assumed that the wealth measured is homogene ous, or so nearly so as to admit of measurement by a given unit. If different qualities or grades have to be distin guished, the amount of each quality or grade requires sepa rate measurement. A continuous gradation in quality, such as is usually found in real estate, makes it necessary to distinguish a great number of different qualities. A tract of land of Ioo acres may consist of a dozen different qualities of land, variously adapted to pasture, crops, or other uses. To describe all this land as simply so many “acres" is misleading. It is necessary to specify separately the num ber of acres of “pasture-land,” “wheat-land,” etc. The unit of measure of any kind of wealth, therefore, when fully expressed, implies a description, not only (1) of size, but also (2) of quality; as, for instance, a “pound of granulated sugar.” It is necessary to enumerate the attri SEC. 5] I3 WEALTH butes of the particular wealth under consideration, or enough of these attributes to distinguish that species of wealth from others with which it might be confused. Thus it is often necessary to specify what “grade ’’ or “brand ” is meant, as “grade A,” “Eagle brand,” etc. Sometimes the special variety is denoted by a “trademark'' or “hall-mark.” Some writers have erroneously supposed that the attri butes of wealth constitute separate and independent “im material" sorts of wealth. But “ rtilityx for instance, is not wealth, though “fertile land" is wealth. “Sweet ness” is not wealth, though “ sweet sº is wealth; “Abeauty” is not wealth, although a “beautiful gem" or other object of art is wealth; “strength” and “power” are not wealth, although “powerful horses,” automobiles, or waterfalls are wealth." § 5. Price We have considered articles of wealth as measured sepa rately. Each kind has its own special unit, as the pound, gallon, or yard. But it is convenient also to measure the combined value of aggregations of wealth. The term “value" introduces the subject of exchange. So much mystery has surrounded the term “value" that we cannot be too careful to obtain a correct and clear idea of it at the outset. In the explanation which follows, the concept of value is made to depend on that of price; that of price, in turn, on that of exchange; and finally, that of exchange on that of transfer. In this section we shall treat of price; * Some people speak of human qualities — strength, beauty, skill, honesty, intelligence, etc. — as though they were wealth. But these bear the same relation to human beings as similar qualities of articles of wealth bear to those articles; and the only way we can logically make them even attri butes of wealth is, as already stated, to call human beings wealth. Then their attributes become attributes of wealth in the broader meaning of that term. - I4 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I and, to observe the order of sequence, we must begin with transfer. Wealth is said to be transferred when it changes owners. A transfer is a change of ownership. Such a change does not necessarily imply a change of place. Ordinarily, of course, the transfer of an article is accompanied by a change in its position, the purchase of tea or sugar being accompanied by the physical delivery of these articles across the counter from dealer to customer; but in many cases such a change of position does not occur, and in the case of real estate it is even impossible. Transfers may be voluntary or involuntary. Examples of involuntary transfers of wealth are: (1) through force and fraud of individuals, as in the case of robbery, burglary, or embezzlement; (2) through force of government, as in the case of taxes, court fines, and “eminent domain.” But at present we have to do only with voluntary transfers. These are of two kinds: (1) one-sided transfers, i.e., gifts and bequests; and (2) reciprocal transfers, or exchanges, which are of most importance for economics. An exchange of wealth, then, is a pair of mutual and voluntary transfers of wealth between two owners, each transfer being in considera tion of the other. When a certain quantity of wealth of one kind is ex changed for a certain quantity of wealth of another kind, we may divide either of the two quantities by the other and obtain what is called the price of the latter. That is, the price of wealth of any given kind is the amount of any other kind of wealth supposed to be exchanged for one unit of the given kind of wealth. Thus if Ioo bushels of wheat are ex changed for 75 dollars of gold, the price of the wheat in terms of gold is 75 + Ioo, or three-fourths of a dollar of gold per bushel of wheat. Contrariwise, the price of gold in terms of wheat is Ioo + 7.5, or one and one-third bushels of wheat per dollar of gold. Thus there are always two prices in any exchange. Practically, however, we usually _-T *_ c * - Sec. Sl WEALTH I5 * . º speak only of one, viz., the price in terms of money, obtained F by dividing the number of units of money by the number of * units of the article exchanged for that money. It follows that, practically, the price in money of any particular sort of * wealth is the amount of money for which a unit of that wealth is exchanged. The fact that wealth is exchangeable and in the civilized world is constantly changing ownership is of great importance for our study. Articles of wealth which 3 are seldom exchanged, such as public parks, are not com ~ monly thought of as wealth at all, although logically they .s * must be included in that category. * J : While it is true that any two kinds of wealth may be exchanged, some kinds of wealth are more acceptable in ex s change than others. Money primarily means wealth which is generally acceptable in exchange. Here for the first time y we reach a preliminary definition of money. This definition is based on the most important characteristic of money — * its exchangeability. An exchange in which money does not : figure is called barter. An exchange in which money does figure is called a purchase and sale – a purchase for the * man who parts with the money (or its representative, a check), a sale for the man who receives it. Originally, all , exchange was barter, but to-day most exchange is, as we * : all know, purchase and sale. S- In order that there may be a price, it is not necessary that the exchange in question shall actually take place. It may be only a contemplated exchange. A real estate agent often has an “asking price ’’; that is, a price at which he tries to sell. This is usually above the price of any actual sale which may occur later. In the same way there is often a “bidding price,” which is usually below the price of actual sale. Hence, the price of actual sale usually lies between the price first bid and the price first asked. But it sometimes happens that the bidder refuses to raise his bidding price, and the seller refuses to lower his asking price enough to bring the two together. In such a case no sale takes place, I6 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I and the only prices are those bid and asked. For many commodities the trade journals report, preferably, prices of actual sales; but, where there have been no sales, they simply report the prices bid or asked, or both. When there is no sale, especially when there is no price bid or asked, it is not so easy to answer the question: What is the price? Recourse is then had to an “appraisal,” which is simply a more or less skillful guess as to what price the article would or should bring. Appraising or guessing at prices is often very difficult. It frequently has to be em ployed, however, by the government, for the purpose of assessing taxes and customs duties and condemning land; by insurance companies for settling claims and adjusting losses; by merchants for making up inventories and similar statements; and by statisticians for numerous purposes. In fact, some people make a living by appraising wealth on which, for one purpose or another, a price of some sort must be set. The purpose evidently makes a great differ ence in the appraisal. Sometimes we want to know the price for which an article could be sold in an immediate forced sale; sometimes, the price it might be expected to bring if a reasonable time were allowed; sometimes, the price the owner would probably take; sometimes, the price a purchaser would probably give. These prices may all be different. A family portrait may be worth a big price to the owner, and yet bring next to nothing if sold to strangers. The owner would naturally appraise it at a high figure if he wished to insure it against fire, but if he should try to bor row money on it from a pawnbroker, the appraisal would undoubtedly be low. Consequently, in applying an appraisal, we encounter many difficulties because the parties involved usually have some interest to serve. When a farmer has land for sale, he will hold it at a high price to prospective purchasers, but will enter it, if the truth must be told, at a low price on the tax list. When a fire loss is adjusted, the two conflict Sec. 6] WEALTH 17 ing interests, viz., the “insured ” and the “company,” are usually represented by two experts, who in case of disagree ment call in a third. § 6. Value Having succeeded in defining the price of any kind of wealth, we may next proceed to define the value of any given quantity of that wealth. The value of a given quantity of wealth is that quantity multiplied by the price." Arithmetic ally expressed, if the price of wheat is # of a dollar per bushel, then a lot consisting of 3ooo bushels would have a value of 3ooo times # of a dollar, or 2000 dollars. Algebraically ex pressed, if the price of any good is p and its quantity is Q, its value is expressed as p0. In other words, the value of a certain quantity of one kind of wealth at a given price is the quantity of some other kind for which it would be exchanged, if the whole quantity were exchanged at the price set. The distinctions between quantity, price, and value of wealth may be illustrated by an inventory such as the fol lowing: — QUANTITY Shoes . . . . Beef . . . . . Dwelling house . Wheat . . . . PRICE IN TERMS OF WHEAT . . Iooo pairs |4} bu. *per pair . 3oo lb. # bu. per pound . 1 house | Io,000 bu. per house . . Ioo bu. I bu. per bushel VALUE IN TERMs of we eat 42.5o bu. 6o bu. Io,0oo bu. Ioo bu. * This definition of value departs from the usage of some textbooks, but follows closely that of business men and practical statisticians. Economists have sometimes confined “price” to what is in this book called money price and applied the term “value” to what is here called price. Other econo mists have used the term “price” in the sense of market price — what an article actually sells for — and “value” in the sense of appraised price or reasonable price—what it ought to sell for. Still others have used the term “price” in the sense employed in this book, but “value” in the sense of the degree of esteem in which an article is held — what in this book will later be called “marginal utility” or “marginal desirability.” * “Bushels” refers to bushels of wheat throughout this table. C I8 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I The three columns must be carefully distinguished. Only in special cases can any two of the three magnitudes, quantity, price, and value, be identical. The table illus trates these special cases. Thus in the last line we find quantity and value identical because, in this special case, the value of the good is reckoned in terms of itself, wheat in wheat. In the line above, price and value are identical because, in this special case, the quantity valued is only one unit. The value of one house is the price per house. The measurement of various items of wealth in respect of “value,” expressed in terms of a single commodity, such as wheat or money, has one great advantage over its meas urement in respect of “quantity.” This advantage is that it enables us to translate many kinds of wealth into one kind and thus to add them all together. To add up the “quantity” column would be ridiculous, because pairs of shoes, pounds of beef, houses, and bushels of wheat are unlike quantities. But the items in the last column (representing values), being expressed in a single common unit (the bushel), may be added together de spite the diversity of the various articles thus valued in bushels of wheat. Since prices and values are usually expressed in terms of money — the most exchangeable kind of wealth — money may be said to bring uniformity of measurement out of diversity. In other words, it is not only a medium of ex change, but it can be used also as a measure of value. It serves as a means of comparing values of different things by expressing them both in a common denominator. It would be far more trouble to compare each article directly with every other article, for there would be many more com parisons. Although this reduction to a common measure is a great practical convenience, we must not imagine that it gives what could in any fair sense be called “the only true measure" Sec. 6] WEALTH I9 of wealth. In fact, to measure the amount of wealth by its value — i.e., its money value – is often misleading. The money value of car wheels exported from the United States in one month was $12,000 and in a later month, $15,000, from which fact we might infer that the quantity of these exports had increased. But the number of car wheels exported in the first of those two months was 2200, and in the second only 21oo, showing a decrease. The price had increased faster than the number had decreased. Likewise, the figures for imports of coffee in these periods show a decline in dollars, despite an increase in pounds. Here the price had fallen faster than the number of pounds had risen. It is conceivable that the quantity of every article might decrease, and yet the price simultaneously increase so much that there would be an apparent increase of wealth when there really was nothing of the kind. This is apt to be the case in times of inflation of the currency. Even when we are confessedly trying to measure the value of wealth and not its quantity, it is difficult or impossible to find a right way. Imports into the United States from Mexico in one year were worth twenty-eight millions of American gold dollars, and ten years later their value was forty millions — an increase in value of forty-two per cent; but these very same imports measured in Mexican silver dollars were forty-one millions in the first year and ninety millions in the second – an increase in value of nearly one hundred and twenty per cent. These two rates of increase, although they represent exactly the same facts, do not agree with each other; yet the American merchant reckons the values one way, and the Mexican merchant, the other. In a sense both are right; that is to say, both are true state ments of the value of the articles imported, one of the value in gold and the other of the value in silver. If the value were to be measured in iron, copper, coal, cotton, or any other article, we should have many other different “values,” no two of which would necessarily agree. “The 2O ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I value of wealth,” therefore, is an incomplete phrase; to be definite we should say, “the value of wealth in terms of gold,” or in terms of some other particular article. Hence we cannot employ such values for comparing different groups of wealth, except under certain conditions, and to a limited degree. To compare the wealth values of distant places or times — as America and China, Ancient Rome and Modern Italy — will inevitably give conflicting and unsatisfactory results. § 7. Limit of Accuracy in Economic Measurements We have learned how the three magnitudes — quantity, price, and value of wealth — are usually measured, and that their measurement is practically a very inaccurate affair. Yet in the minds of most persons, even of business men, the degree of accuracy attainable is exaggerated. Even in the measurement of the mere quantities of wealth there are two sources of error; for every such measurement includes, as we have seen, two elements: a unit and a number or ratio (as the pound, and the number of pounds); and both the unit and the number or ratio may be inaccurate. In modern times the first source of error — that of the unit — is practically eliminated. Our units of weight and meas ure are standardized by law, and a pound in California is, for all practical purposes, equal to a pound in Connecticut. There is, moreover, at Washington a national bureau and a special building for preserving and testing standards of measurement. Different towns have their sealers of weights and measures, to prevent error through ignorance or fraud. Fraud and error still exist, but are much rarer than in former times. The Egyptians are said to have been un able to test the accuracy of their units of length closer than to 1 part in 350. The Roman weights were true only to 1 part in 50. And when we go back to primitive units, we find that they were very rough indeed. A yard was SEc. 7] WEALTH 2I probably at first the length around the waist, which naturally was apt to vary considerably. So also the distance between the elbow and the end of the finger was taken as a unit and called the ell. Fraud was, therefore, as easy as it was common. At Bergen, in Norway, among other relics of the old Hanseatic League, are the scales used for buying and selling fish, with two sorts of weights used, one con siderably heavier than the other. The heavier were used for buying and the lighter for selling ! Such tampering with weights and measures is probably much less frequent to-day, although instances of short weights, as in the “sugar trust frauds,” are often brought to light. To-day, therefore, the chief source of error lies not in the unit, but in the ratio of the quantity of wealth to that unit. In retail trade the inaccuracy from this source is very great. If we get our apples or potatoes measured correctly within five per cent, we are fortunate. Wholesale transactions are more accurate. Probably the greatest degree of accu racy ever attained in commercial measurements is on the mint scales employed by the federal government in Phila delphia and San Francisco. These scales weigh accurately to within about one part in two million. Besides the two sources of error in the measurement of mere quantity, when we proceed from quantity to value, we introduce still a third source of inaccuracy, viz., the price factor by which we multiply the quantity in order to get the value. This is especially true if the price be merely an “appraised " price. The price in an actual sale is an absolute fact and cannot be said to have any inaccuracy; but the price at which we estimate that a thing would sell under certain conditions is always uncertain. In the case of “staple '' articles, i.e., articles regularly on the market, a dealer can often appraise correctly within one per cent. Real estate in certain parts of a city where sales are active can sometimes be appraised correctly within five or ten per cent, but in the “dead " or out-of-the-way parts of some 22 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. I towns where sales are infrequent, the appraisement be comes merely a rough guess. Again, in the country districts, while farms in the settled parts of Iowa and Texas can be appraised within ten or fifteen per cent, in the backward parts even an expert's valuation is often proved wrong by more than fifty per cent. And where a sale of the article in question is scarcely conceivable, an appraisement is almost out of the question. To estimate the value of Yellow stone Park is impossible, unless we allow ourselves very wide limits of error." * Still wider limits must be allowed when we try to value human beings. We can often give a lower limit, but seldom an upper one. The estimates may vary enormously with the point of view. It is sometimes said, “If I could buy Mr. So-and-so at my valuation and sell him at his, I'd get rich.” Freemen are seldom appraised at all. When the slaves in the South became freemen, they ceased to be appraised as wealth. The result has been somewhat confusing to our census statistics. The “Manufacturers’ Record” of Baltimore recently issued figures showing a sharp drop in the assessed valuations of wealth in the South after the war. The inference was drawn that the value of wealth had immensely decreased; but a large part of this so-called decrease consisted merely in the change of ownership of slaves from their old masters to themselves, and their consequent omis sion as items of value. Any valuation of freemen, should exceed that of slaves; but even on the basis of slave values the total value of the human beings in any country is always greatly in excess of the total value of all other wealth. CHAPTER II PROPERTY § 1. The Benefits of Wealth THE definition of wealth which has been given restricts it to concrete material objects owned by man. Accord ingly, wealth has two essential attributes: materiality and ownership. Its materiality was the subject of the preceding Chapter; its ownership will be the subject of the present chapter. To own wealth is to have a right to the benefits of wealth, and before proceeding further with the discussion of owner ship, we must consider these “benefits" of wealth. To own a loaf of bread means nothing more nor less than to have the right to benefit by it – i.e., to eat it, sell it, or otherwise employ it to satisfy one's desires. To own a suit of clothes is to have the right to wear it. To own a carriage is to have the right to drive in it or otherwise utilize it as long as it lasts. To own a plot of land means to have the right to use it forever. The ultimate objects for which wealth exists are the benefits which it confers. If some one should give you a house on condition that you should never use it, sell it, rent it, or give it away, you might be justified in refus ing it as worthless. Benefits may also be rendered by free human beings (who, according to our broader definition, are included under wealth). Such benefits are then usually called services ren dered or work done. When rendered by things rather than persons, benefits are commonly called uses. Some 23 24 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. II times benefits consist of positive advantages and sometimes of the prevention of disadvantages. Benefits, then, mean desirable events obtained or undesirable events averted by means of wealth or free human beings. For example, when a loom changes yarn into cloth, the transformation is a de sirable change due to the loom; it is a benefit conferred or performed by the loom. The benefit from a plow is the turning up of the soil. The benefits or services performed by a bricklayer consist in the laying of bricks. The benefits or uses conferred by a fence around a farm consist in pre venting the cattle from roaming away. The dikes in Hol land confer the benefit of keeping out the ocean. The benefits conferred by a diamond necklace consist in its pleasing glitter. Many articles confer benefits on their owners by yielding them money. The benefit to the landlord from the land or building which he lets is the receipt by him of rent. The benefit to the owners of a railway from the railway is the receipt by them of their dividends. But not all benefits, of course, are simply the receipt of money. To be desirable to the owner, an article must confer bene fits on the owner, but not necessarily on the community at large. For instance, the noise of a factory whistle may be a nuisance to the community, but as long as it is service able to the owner of the factory, it is for him a benefit. Benefits to the owner and benefits to society may be very different or may be mutually incompatible. The benefits to society are of the greater importance, but, under our present system of ownership, the benefits to the owner control the prices and values of wealth. In order, therefore, to under stand prices and values as they are actually determined, we must fix our attention for the present on the benefits to the owner rather than on those to society. Benefits may be measured just as wealth may be measured, although the units of measurement are, of course, not the same. We measure some benefits by number—as when we * l, s Sec. 2) 25 PROPERTY count the strokes of a printing press. We measure other benefits by time — as when we reckon a laborer's work by the number of hours or days during which he works. Some benefits we measure by the quantity of wealth which is pro duced or treated — as when the work of a coal miner is measured by the amount of coal he mines, or when the use of a loom is measured by the number of yards of cloth it weaves, or when the services of a lawn-mowing outfit are measured by the number of acres covered. The measure ment of services or benefits is usually rougher than that of wealth, because it is more difficult to establish units of measure. The shelter of a house or the use or “wear” of a suit of clothes is difficult to measure accurately. To save trouble, benefits are usually measured by time, although, as soon as it becomes profitable to do so, the tendency is to establish a more satisfactory measure “by the piece.” When we have measured the benefits of wealth or of free human beings, we may apply to them the same concepts of transfer, exchange, price, and value, which, in the last chap ter, we applied to wealth. We have seen that wealth may be exchanged. The same is true of benefits. In fact, every exchange is an exchange of benefits; for to exchange wealth is really to exchange the benefits of wealth, the only object in getting wealth being to get its benefits. - § 2. The Costs of Wealth Opposed to the benefits of wealth are its costs. Costs may be called negative benefits. The purpose of wealth is to benefit its owner; that is, to cause to happen what he desires to happen, and to prevent from happening what he desires not to happen. But often wealth can work no benefit without entailing some cost, i.e., preventing what is desirable or occasioning what is undesirable. For instance, one cannot enjoy the benefits of a dwelling without the costs of taking care of it, either through the actual labor of clean 26 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. II ing, heating, repairing, and keeping it in order, or the pay ment of money to servants for such purposes; one cannot get the benefit of flour without assuming the cost of knead ing and baking it into bread; one cannot get the benefit of a farm without the cost of tilling it. Whatever wealth brings about to the pleasure of the owner is a benefit; whatever it brings about to his displeasure is a cost. He assumes the costs only as a means of securing the benefits. Costs are thus the necessary evils which must be if we are to obtain the good which wealth affords. Like benefits, costs are not only occasioned by wealth, but also by free human beings. An employer can get benefits from a workman only at the cost of pay ing him wages; an independent workman can get bene fits from his own exertions only at the cost of his own labor. - The costs of wealth or of free human beings may, of course, be measured, just as benefits are measured — by number, by time, or by other appropriate units; and costs when thus measured may, by price and value, be translated into terms of money precisely like the opposite items—benefits. We must beware of assuming that cost is always in the form of an expenditure of money. Such money cost has received exaggerated importance in the eyes of business men and has tended to hide the more important and funda mental kind of cost, namely, labor. Even labor appears to the employer in the guise of a money cost – the expenditure of wages. This expenditure, however, is not itself labor. Those who feel a real labor cost are the laborers themselves. It is by their physical and mental exertions that the work of the world is chiefly done. § 3. Property, the Right to Benefits We have said that to own wealth means to have the right to its benefits. We have seen what is meant by SEC. 3] PROPERTY 27 “benefits,” and shall next examine what is meant by “rights.” " A property right is the liberty or permit (under the sanc tion and protection of custom and law) to enjoy benefits of wealth (in its broader sense) while assuming the costs which those benefits entail. The term “property" is merely an abbreviation for “property right” or “property rights.” Just as different kinds of wealth are more or less exchange able, so different kinds of property rights differ greatly in exchangeability. Those forms which are most easily and commonly exchanged are of most importance for our study. Those the exchange of which is infrequent, difficult, or for bidden, are in fact seldom thought of as property rights at all, although logically they must be included in that cate gory. In the modern world the right of a parent over a child or of a husband over a wife is not by ordinary usage called property; for, except in certain remote corners of the earth, their exchange is tabooed. It will be observed that property rights, unlike wealth or benefits, are not physical objects nor events, but are abstract social relations. A property right is not a thing. It is that relation of man to things, called ownership. It is in this human relationship to wealth that we are most interested, and not in the physical objects as such. The benefits flowing from wealth require time for their occurrence and are therefore either past or future. The past and the future are separated by the present, which is a mere point of time. The only benefits from wealth which can be owned at this present point of time are future benefits. Past benefits have vanished. When a man owns any form of property, he owns a right to future benefits. The idea of “futurity” is, therefore, implied in our definition of property, which may, therefore, be more explicitly expressed as follows: * As we have seen that “benefits” may be occasioned not only by wealth in its narrow sense, but by free human beings, we shall consider “rights” to benefits from both of these sources. 28 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. II Property is the right to future benefits of wealth (in its broader sense). It is also to be observed that the future is always uncertain; no man can ever tell in advance exactly how much future benefit he can obtain; he can only take the chances and risks involved. Consequently, the idea of un certainty is also implied in our definition of property, which may, therefore, be still more explicitly expressed as follows: Property is the right to the more or less probable future benefits of wealth (in its broader sense). If a man has the right to all the benefits which may come in the future from a particular article of wealth, he is said to have its complete ownership, or its ownership without encumbrance. If he has a right to only some of the bene fits from a particular article of wealth, he is said to own that wealth partially, or to “ have an interest" in it. When two brothers own a farm equally in partnership, each is a part owner; each has a half interest in the farm; that is, each has a right to half of the benefits to be had from the farm. What is divided between the two brothers is not the farm, but the benefits of the farm. To emphasize this fact, the law describes each brother's share as an “undivided half interest.” Partnership rights are usually employed only when the number of coöwners is small. When the number is large, the ownership is usually subdivided into shares of stock; but the principle is the same – each individual owns a right to a certain fraction of the benefits which come to the owners. After the quantities of property of different kinds are measured, we may apply the same concepts of transfer, exchange, price, and value which have already been applied to wealth and benefits, each particular kind being measured in its own particular unit. Consider, for example, the prop erty called stock in the Pennsylvania Railway Company. This is measured by the “number of shares,” the share here being the unit of measurement. It is important that the student should become accus i SEc. 3] PROPERTY 29 tomed to see the real basis underlying property rights. This basis is either wealth or free persons, or both. Practically it is usually wealth. A mortgage is based on land, and great care is taken not to have the mortgage too large for the basis on which it rests. Railroad stocks and bonds are based on the real railway. Personal notes are based partly on the person issuing them and partly on his wealth. A street railway franchise is a property right, the physical basis of which consists in the streets. Sometimes the property rights are removed several steps from the real basis. If a number of factories are combined into a “trust,” the origi nal stockholders surrender their stock certificates to trustees and receive in their place trust certificates. Their rights are then a claim against the trustees who hold the stock which represents the factories. The ultimate basis for their rights is still the factories, but their ownership is indirect. The future benefits flowing from wealth may be compared to a pennant attached to a flagstaff — a long streamer stretching out into the future. Two of the possible ways in which the present ownership of these benefits may be sub divided are indicated in Fig. 1. Here are two “streamers ” representing the streams of benefits which may come from a dwelling house. These begin at the present and stretch out indefinitely into the future. If two brothers own the house in partnership, each has a right to half the shelter of the house, i.e., to half of its benefits; the benefits are therefore divided, so to speak, longitudinally in time. But if the house is rented, the division of benefits between the tenant and the landlord is transverse, as shown in the lower “streamer" of the diagram. The tenant has all the shelter of the house until the time when his lease is to expire, while the right to all shelter beyond the time of the lease rests in the landlord, either to use himself or to sell to others by new leases. These are not, of course, the only ways in which future benefits may be parceled out among their several owners, 3o ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. II but they are the principal and usual modes of sub division. In common speech, the minor rights to wealth are not ordinarily dignified as rights of ownership. Thus a tenant's right in the dwelling B's st-ARE of FUTURE BENEFITs. T he occupies is sharply A's 5HARE of FUTURE BENEFITS, } distinguished from the right of the owner. Yet, strictly speaking, every right to the benefits of wealth or to the services of free - TENANTs LANDLORD's SHARE SHARE human beings, how uman beings, ever insignificant that right may g y be, is a Dpart ownership. When an PRESENT y INSTANT FIG. I owner of land wishes to give an unencum bered title, he finds it necessary to extinguish all out standing leases, or claims for future benefits, often at considerable cost. It is the total ownership which he is selling, and the total ownership always includes the owner ship which the tenant enjoys. Thus the tenant of a dwelling is, to a very slight extent, a part owner of that dwelling. In the same way the employer is, to a very slight extent, a part owner of the employee. § 4. The Relation between Wealth and Property We have thus far considered three very important and fundamental concepts: wealth, benefits, and property. A convenient collective term for all of them is “goods.” Wealth and property are only present representatives of future benefits and future costs. Wealth (in its broader sense) is the present means by which we secure future bene fits; while property is the present right to these benefits, SEc. 4) PROPERTY 31 and so to the wealth (in its broader sense) which yields them. It follows that wealth (in its broader sense) on the one hand, and property rights on the other, may be said to correspond to one another. The wealth (including free human beings) consists in real tangible things, while the property rights represent intangible, abstract relations which persons, as owners, hold toward them (the wealth, including free human beings). Wealth and persons are the important things; property is the human right of ownership of the wealth or of the services of free human beings. In specific cases we can readily see the correspondence between the wealth and its ownership. In fact, in cases where wealth is owned unencumbered or completely, the correspondence is altogether too ob vious; so obvious that in ordinary parlance the two terms, “wealth '' and “property,” become confused, as when speaking of a piece of wealth, in the form, say, of land, we call it a “piece of property.” On the other hand, where the ownership is minutely subdivided, the wealth and the property rights to that wealth become so dissociated in our minds that we are apt to fall into the opposite error, and entirely lose sight of their connection. For instance, when railway shares are sold in Wall Street, the investor rarely thinks of those shares as connected with any actual wealth. All that he sees are the engraved certificates of his property rights; he has no visual picture of the railway. Sometimes the rights are so far separated from the thing to which the rights relate, that people are unaware that there is anything behind the rights at all, and delude themselves with the notion that there need not be anything behind them. A government bond, for instance, is often regarded as a kind of property behind which there is no wealth. But if we examine the case, we shall find that the wealth of the entire community is behind this property right; for it is by means of the taxing power that the bonds are to be paid, and this taxing power can 32 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. II only be effective by means of wealth (including freemen) as sources of income. For cities, in fact, this is definitely recognized; there is usually a legal debt limit expressed in terms of the value of taxable wealth, to insure the creditors that there shall always be sufficient real wealth behind the city bonds to make their ultimate payment SeCure. Not only should the student clearly distinguish in his mind between the three important concepts, wealth (in cluding man), benefits and property, but he should avoid confusing any of these with a fourth relatively unimpor tant concept, namely, certificates of ownership. To avoid misunderstanding, it is often necessary that property rights should be evidenced by written documents. Examples of such written evidence or certification of property rights are deeds for real estate, receipted bills for goods bought and paid for, engraved stock certificates, railway tickets, signed prom issory notes, written contracts with laborers to “work out” a sum of money advanced, etc. It is clear, however, that such written evidence of property rights is very different from the property rights themselves; and in many cases such rights exist without any written evidence. Thus, the farmer who rears his own cattle, or horses, or sheep, usually has no written evidence of property rights in them. Or, two brothers might own and operate a farm in partnership, without any written evidence as to their partnership rights, i.e., their respective rights in the products of the farm. Or, again, one person might, without written evidence, lease (say) a cottage for a season from a friend. In all these cases, there are no documentary evidences of property rights. Yet in all three cases property rights exist. In the first case the right is complete; in the other two cases partial, the benefits being subdivided, -in one case lon gitudinally, in the other, transversely. SEc. 5] PROPERTY 33 § 5. Table of Typical Property Rights The following table indicates the most important types of property, and shows in each case the wealth on which the property right is based and the benefits accruing from that wealth. The most important forms are: unencumbered, stocks, bonds, notes, leases, and partnership rights. TYPICAL CASES ILLUSTRATING THE EXISTENCE OF WEALTH BEHIND PROPERTY RIGHTS WEALTH on which CERTIFICATE Naws or caseſ." Hº ;º. º.º. Unencumbered Yielding crops Farm Right to all use | Deed of farm for ever Partnership Yiclqing profits One Dry goods from sale partner's Articles “undivided ” fractional in of agreement terest Joint Stock Railway Yielding profits. The shares stock of Stock certifi cate Street Franchisel Street Use of same for Right to run Charter passage, etc. cars through Lease or Hire | Dwelling Use of same for Right of tenant Lease Railway Ticket Railway Transportation | Right to speci- Ticket Railway Bond Payment of “in- Right to same Bond it shelter, etc. till fixed date fied trip Railway terest" and “principal'' and contin- certifi Cate gent right to foreclose Personal Note All the posses- || Payments sions of the and signer Work due from Workmen Contract Labor Right to same | Note Work in de fault thereof, right to collat eral security Right of employ- Written er to perform- tract ance of same con 34 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. II § 6. Practical Problems of Property We have seen that wealth (including man), on the one hand, and property rights, on the other, correspond to each other. When we treat of the welfare of a community, we think rather of wealth (in its broader sense) than of prop erty. When we treat of the welfare of an individual, we think rather of property than of wealth. This fact of corre spondence between property rights, on the one hand, and wealth (including man), on the other, should be empha sized, because it will save us from confusions which are all too common, and it will save us also from many practical blunders growing out of these confusions. If our State legislators understood this, there would be less of the iniquitous double taxation that is the bane of the present systems of State and local taxation. Such unjust taxation is illustrated by the case of the Massachusetts factory owner who decided to transfer his property to a stock company of which he himself should hold all the stock. Previously he paid taxes only on the factory itself; but when the “com pany” was formed (under a Maine charter), the tax collector came along and informed him that henceforth not only must the “company ” pay taxes on the factory, but that he personally must pay taxes on the stock also, since stock in a Maine company is taxable “personal property.” Thus the owner was taxed both on the stock which repre sented the factory and on the factory itself. Instances of double taxation are quite common in the United States, though they are not all so self-evident as this. It is not within the scope of this book to discuss taxation or other practical problems of economics. The object of this section is merely to point out what practical problems are related to “property.” Many of the most important problems of economic policy are problems of the form of ownership of wealth. SEc. 6] PROPERTY 35 The great question of slavery, for instance, turned upon the question whether one man should be owned by another. A more modern problem of property is that of perpetual franchises. Is it, for instance, good public policy to grant to a street railway company in perpetuity the right to use a city's streets? Or ought we to fix a time limit, say fifty years, after which the right shall revert to the city? A kindred question has been raised as to private property in land. Is it wise public policy that the present form of land ownership in fee simple should continue? Ought a man to have the right to a piece of land forever, perhaps abus ing that right, obstructing others, and neglecting the oppor tunities which it affords; or should the government own the land and lease it to individuals for limited periods? This question is now being discussed with reference to our mineral lands, and particularly our coal lands in Alaska. Questions of land ownership have in all ages vexed men's minds and been the source of social unrest. Rome had her agrarian troubles, not unlike those of modern England and Ireland. The right to bequeath property is also a prime source of trouble. This right to dispose of property by will has not always been recognized. It was developed by the Romans, from whose system of law we borrowed it. Even now it is a limited right, and its exercise differs with law and custom. These differences are responsible for peasant proprietorship in France and for primogeniture in England. The right has, indeed, been limited so as to prevent the perpetual tying-up of an estate by a testator. Its further limitation will prob ably be one of the problems of the future. An even broader question of the same sort is the question of socialism. Shall we discontinue what is called private property, except in the things that we wear and eat, and pos sibly the houses in which we live? That is, shall we allow our railways and our factories to be owned by private indi viduals? Or shall they be owned by the community at 36 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. II large so that we may all have shares in them, as we already have in the post office and the government printing office? These are some of the greatest problems in economics; and they are problems concerning the ownership of wealth. The answers to these questions do not come within the pur pose of this book, which is concerned merely with principles. * The problems are mentioned, however, as illustrating the -** application of principles here discussed. CHAPTER III CAPITAL § 1. Capital and Income IN the foregoing chapters we have set forth several funda mental concepts of economics – wealth, property, benefits, price, and value. We have seen that wealth in its broader sense includes human beings, and that property in its broader sense includes all rights whatsoever; that benefits are the desirable occurrences which happen through wealth (in its broader sense); that prices are the ratios of exchange between quantities of goods of various kinds (wealth, property, or benefits); and that value is price multiplied by quantity. These concepts are the chief tools needed in economic study. Little has yet been said about the relation of these various magnitudes to time. When we speak of a certain quantity of wealth, benefits, or property, we may refer either (1) to a quantity existing at a particular instant of time, or (2) to a quantity produced, exchanged, transported, or con sumed during a particular period of time. The first is a stock of “goods”; the second is a flow of “goods.” Ex amples of stocks are the stock in trade of a merchant on a certain date, the cargo of wheat on board a ship, the amount of food in a pantry at a particular instant, the number of shares of stock owned by a particular individual in a particular corporation at a particular date. Examples of flows are the sales of merchandise made in the course of a given month by a given merchant, the amount of wheat 37 38 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III imported into a given country during a given year, the quantity of food consumed by a family in a given week, the sales of a given kind of stock on the New York Stock Exchange during a given number of days, the transporta tion accomplished by a railway in the course of a certain year, the work done by a given man in a given time. The most important purpose of the distinction between a stock and a flowis to differentiate between capital and income. Capital is a stock, and income a flow. This, however, is not the only difference between capital and income. There is another, equally important; namely, that capital consists of wealth, while income consists of benefits. We have, therefore, the following definitions: A stock of wealth existing at a given instant of time is called capital; a flow of benefits from wealth through a period of time is called income. Many authors restrict the name capital to a particular kind or species of wealth, or to wealth used for a particular purpose, such as the production of new wealth; in short, to some specific part of wealth instead of any or all of it. Such a limitation, however, is not only difficult to make, but cripples the usefulness of the concept in economic analysis." A dwelling house is capital; the shelter or the rent it affords, during any given period of time, is income. The railways of the country are capital; their benefits (in the form of transportation or its equivalent in dividends) are the income they yield. The term capital is also applied to a stock or fund of property existing at an instant of time. But such “capital property” is not, of course, in addition to “cap *Just as wealth may be considered in a broader sense as including freemen, so capital may also be considered in this broader sense. Thus an individual, because of his ability to work, may be considered as capital, while the benefits resulting from his labor (services rendered employer or self) should be considered as income. However, in the following dis cussion of “capital,” we shall, except where the contrary is expressly stated, use the term in its narrower sense. SEc. 2] CAPITAL 39 ital wealth,” but merely instead of it; for we have seen that wealth and property are coextensive. The only true capital of society as a whole is its capital-wealth, – its lands, railways, factories, dwellings, and in its broader sense its human inhabitants also; but since the owner ship of many of these things is subdivided, the capital of an individual can often be stated only in terms of property—his stocks, bonds, mortgages, personal notes, etc. § 2. Capital-goods, Capital-value, Capital-balance We have defined capital as a stock of wealth existing at a given point of time. An instantaneous photograph of wealth would reveal, not only a stock of durable wealth, but also a stock of wealth more rapid in consumption. It would disclose, not the annual procession of such wealth, but the members of that procession that had not yet passed off the stage of existence, however swiftly they might be moving across it. It would show trainloads of meat, eggs, and milk in transit, as well as the contents of private store rooms, ice chests, and wine cellars. Even the supplies on the table of a man bolting his dinner would find a place. So the clothes in one's wardrobe, or on one's back, the tobacco in a smoker's pouch or pipe, the oil in the can or lamp, would all be elements in this flashlight picture. We have seen in the last two chapters that wealth and property may be measured either by quantities (such as so many bushels or pounds or so many shares or bonds of a particular description) or by value (such as so many dollars' worth). When a given collection of capital is measured in terms of the quantities of the various goods of which it is composed, it is called capital-wealth or capital-property or, to include either, capital-goods; when it is measured in terms of its value, it is sometimes called capital-value. One of the best methods of understanding the nature of capital is to understand the method of keeping capital ac 4O ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III counts. We shall, therefore, in the remainder of this chapter indicate some of the principles of capital accounting. Such a study is useful not only because it enables us to keep our own capital accounts and to understand the accounts of banks, railways, and other institutions as published, but, what is more important for our present purpose, because it shows how in the present complicated world of divided ownership of capital, with its interrelated arrangement of stocks, bonds, debts, and credits, the capitals of individuals dovetail into one another, forming together the capital of the community. - A capital account or balance sheet is a statement of the quantity and value of the wealth of a specific owner at any instant of time. It consists of two columns — the assets and the liabilities—the positive and negative items of his capital. The liabilities of an owner are his debts and obligations to others; that is, they are the property rights of others for which this owner is responsible. The assets or resources of the owner include all his capital, irrespective of his liabilities. These assets include both the capital which makes good the liabilities, and that, if any, in excess of the liabilities. The owner may be either a physical human being or an abstract entity called a “fictitious person’’ made up of a collection of human beings and keeping a balance sheet distinct from those of the individuals composing it. Ex amples of fictitious persons are an association, a partner ship, a joint stock company, a government. With respect to a debt or liability, the person who owes it is the debtor, and the person owed is the creditor. The difference in value between the total assets and the total liabilities in any capital account is called the net capital, or capital balance of the person or company whose account it is. A fictitious person is to be regarded as owning all the capital nominally intrusted to it and as owing its individ ual members for their respective shares; consequently, there is no net capital-balance belonging to the fictitious SEc. 2) CAPITAL 4I person, although in most cases there is a liability item called capital which represents what is owed to those most responsible for the management of the business. The most important example of a fictitious person is a joint stock company. This may be roughly described as an aggregation of individuals uniting for the purpose of holding property jointly, and so organized that the in dividual shares of ownership and management are repre sented by “stock certificates.” Associated with the stock holders are usually also bondholders without voting power, but with the right to receive fixed payments stipulated in the bonds which they hold. The “capital” item in the capital account of a joint stock company is a liability due to the stockholders. It represents what is left after the value of all other liabilities is deducted from the value of the assets. The items in a capital account are constantly changing, as also their values; so that, after one statement of assets and liabilities is drawn up, and another is constructed at a later time, the balancing item, or net capital, may have changed considerably. However, bookkeepers are accus tomed to keep this recorded “capital” or “capital-balance” item unchanged from the beginning of their account, and to characterize any increase of it as “surplus” or “un divided profits” rather than as capital. There are several reasons for this bookkeeping policy. In the first place, the less often the bookkeeper's entries are altered, the simpler the bookkeeping. Again, by stating separately the original capital and its later increase, the books show at a glance what the history of the individual or company has been as to the accumulations of net capital. Finally, in the case of joint stock companies, the stockholders' capital is represented by stock certificates, the engraved “face value " of which cannot conveniently be altered to keep pace with changes in real value. Consequently, it is customary for bookkeepers to maintain the book 42 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III value of the recorded “capital,” or “capital-balance,” equal to the face value of the certificates. But this book keeping policy does not alter the fact that at a given instant the stockholders' capital consists of the entire excess of as sets over liabilities, including in that excess the accumulated surplus and undivided profits. If the excess of assets over liabilities be added to the liabilities, the two sides of the account will exactly balance. A capital account so made out is therefore called a “balance sheet.” The following two balance sheets illustrate the accumula tion in a year of that part of capital which bookkeepers sepa rate from the “capital ’’ item and call “surplus.” JANUARY 1, 1910 ASSETS Plant . . . . . LIABILITIES . $200,000 $200,000 Debts . . . . $1oo,0oo Capital (owed to the stockholders) . . Ioo,ooo $200,ooo JANUARY 1, 1911 ASSETS LIABILITIES Plant, etc. . . . . $246,324 $246,324 Debts . . . . . $100,ooo Capital . . . . . Ioo,ooo Surplus . . . . . 46,324 $246,324 Not only is the book item, “capital,” maintained intact as long as possible, but often the surplus also is put in round numbers and kept at the same figure for several succes sive reports. This leads bookkeepers to distinguish a third part of the capital, namely, the odd sum usually existing in addition to the surplus. This third item is called “un divided profits,” and is subject to constant fluctuation from one date to another. The distinction between sur plus and undivided profits is thus merely one of degree. SEc. 2) CAPITAL 43 The three items — capital, surplus, and undivided profits — together make up the total capital-balance due the stock holders. Of this, “capital ’’ represents the original capi tal, “surplus ” the earlier and larger accumulations, and “undivided profits” the later and minor accumulations. The undivided profits are more likely soon to disappear in dividends, i.e., to become divided profits, although this may also happen to the surplus, or even in certain cases to the “capital " itself. We see, then, that the capital of a company, firm, or person, is to be understood in two senses: first, as the item en tered in the balance sheet under that head—the original cap ital; and secondly, this sum plus surplus and undivided profits — the true net capital at the instant under consideration. In the case of a joint stock company, since the stock certificates were issued at the time of the formation of the company, and cannot be perpetually changed, they ordi narily correspond to the original capital instead of the present capital. Recapitalization may be effected, however, by recalling the stock certificates and issuing new ones. In this way the nominal or book value may be either decreased or increased. It is sometimes scaled down because of shrinking assets, and sometimes increased because of new subscrip tions or expanding assets. If, for instance, the original capital was $1oo,0oo, and the present capital (including the surplus and undivided profits) is $300,ooo, it would be pos sible, in order that the total certificates outstanding might become $300,ooo, and the surplus and undivided profits be enrolled as capital, to issue additional stock certificates to the amount of $200,000 free to the holders of the original stock. Such an issue of stock is called a stock dividend. Ordinarily, however, the stock certificates remain as origi nally, and merely increase in value. Thus, if the present capital is $300,ooo, whereas the original capital or the out standing certificates amounted to only $100,000, the “market value " of the shares will be triple the “face 44 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III value "; for the stockholders own a total of $300,ooo, represented by certificates the face value of which is $100,000. § 3. Book and Market Values If, however, we attempt to verify such a relation by refer ence to the company's books, we shall find some discrepancies in the results. For instance, a certain bank of New York recently reported a total capital, surplus, and undivided profits of $1,295,952.59, of which the original capital was only $300,ooo. We should expect, therefore, that the stock certificates, the total face value of which was $300,ooo, would be worth $1,295,952.59; or, in other words, that each stock certificate with a face value of $1oo would be worth $432. The actual selling price, however, was about $700. The discrepancy between $432 and $700 is due to the fact that there are two estimates of the value of capital — one that of the bookkeeper, which is seldom revised and usually conservative, and the other that of the market, which is revised almost daily. The stockholders of this bank were credited by the bookkeeper with owning $1,295,952.59, whereas in reality, the total value of their property was more nearly $2,100,000. The bookkeeper systematically under valued the assets of the bank, and even omitted some valu able assets altogether, such as “good will.” The object of a conservative business man in keeping his books is not to obtain mathematical accuracy, but to make so conservative a valuation as to be well within the requirements of the law and expediency. The law discountenances the valuation of assets above their original cost; and sometimes there is an addi tional motive to undervalue, – the wish to conceal a large surplus, from fear either of competition or of taxation. Of the two valuations of the capital of a company, the bookkeeper's and the market's, the latter, being more fre quently revised, is apt to be the truer of the two, al though it must be remembered that each of them is merely SEc. 4) 45 CAPITAL an appraisement. The ordinary bookkeeper's figures, which have so imposing an appearance of accuracy, are, in reality, and often of necessity, very wide of the mark. For instance, a certain bank recently reported its capital, surplus, and undivided profits at $444,814.40, but at the same time the president of the bank boasted that the bank ing house was entered among the assets at $20,000, while its real value was probably $50,000. Thus the figure giving the capital, surplus, or undivided profits, instead of being correct to the last cent or even the last dollar, was not correct even to the last ten thousand dollars. § 4. Case of Decreasing Capital-balance We have seen that the effect upon the balance sheet of an increase in the value of the assets is to swell the surplus or the undivided profits. Conversely, a shrinkage of value tends to diminish those items. For instance, if the plant of a company having a capital of $100,000 and a surplus of $50,000 depreciates to the extent of $40,000, the effect on the account will be as follows:– ORIGINAL BALANCE SHEET Assets Plant LIABILITIES . . . . $200,ooo.oo Miscellaneous . . IoI,256.42 Debts . . . . . $150,000.oo Capital . . . . Surplus . . . . Undivided profits . $3ol,256.42 Ioo,ooo.oo 50,000.00 1,256.42 $3o1,256.42 PRESENT BALANCE SHEET Assets LIABILITIES Plant . . . . . $160,000.oo Debts Miscellaneous . Capital . . . . Surplus . . . . Undivided profits . IoI,256.42 $261,256.42 . . . . $150,000.oo Ioo,ooo.oo Io,ooo.oo I,256.42 $261,256.42 46 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III Here the shrinkage in the value of the plant, as recorded on the assets side, “comes out of the surplus,” as recorded on the liabilities side. In case the surplus and undivided profits have both been wiped out, the capital itself becomes impaired. In this case the bookkeeper may indicate the result by scaling down the capitalization. This sometimes occurs in banks and trust companies, but not often in ordinary business. It is often avoided by making up the deficiencies through assessment of stockholders or postponement of dividends. Such meas ures are sometimes required by law, as in the case of insur ance companies. Dishonest concerns, however, often conceal their true con dition by the reverse process of exaggerating the value of the assets. Sometimes this is done systematically, as in the case of stock-jobbing concerns. The sums intrusted to unscrupu lous promoters by confiding stockholders are often invested in unwise or fraudulent ways. For instance, take an Oil Well Company in California, of the illegitimate type called “stock-producing wells.” Suppose it borrows $50,000 and collects $50,000 more from the sale of stock (at par), and with this $100,ooopurchases land at a fancy price from friends who collusively agree that a part of the proceeds shall be secretly returned to the promoter. In such a case the books of the bubble concern will show the following figures: — ASSETs Land . LIABILITIES . . . . . $100,000 Debts . Capital $1oo,ooo . . . . . $50,000 . . . . . 50,000 $1oo,0oo But if the land is worth, say, only $60,000, these accounts should have been quite different, viz.: ASSETs Land . . . . . LIABILITIES . $60,000 $60,000 Debts . . Capital . . . . . . Io,0oo $60,000 . . . . $50,000 SEC. 41 ! CAPITAL 47 In other words, the investor has only $10,000 worth of property, instead of the $50,000 which he put in, or 20 cents for every dollar invested. The rest has been diverted into ** the pockets of the promoter and of those in collusion with him. ---This is stock jobbing. It is one example of what, in commercial slang, is called “stock watering,” being an issue of stock whose nominal or face value is greater than the actual capital. Another and more usual use of the term “stock watering” makes it mean not an issue of stock beyond the original cost value of the capital as shown by the actual money paid in, whether or not this be beyond the real commercial capital-value. . Thus a “trust” may buy up a number of factories and then capitalize them far beyond that cost, because the combination of the factories gives them a monopoly value beyond the sum of their values when separate. By this kind of stock watering, conceal ment is made of the fact that the trust is earning an enor mous rate of dividends in proportion to the original invest ment; for the dividends make a much smaller rate on the inflated, or watered, capitalization than on the cost value. Stock watering is usually employed to prevent a knowl edge of the original value of the capital, for instance, to avoid public displeasure, taxation, or legal regulation of the rates charged. It is sometimes said that there is no wrong in such stock watering, so long as it is fully known. This is much like saying that to lie is not wrong, pro vided everybody knows you are lying. Stock watering of the kind described is the exaggeration of the “capital ’’ item entered on the liabilities side of the balance sheet; and, since the two sides must balance, it involves the exaggeration of the assets also. It usually represents an intention to deceive, and through this deceit injury may be done both to buyers of stock and buyers of bonds. The buyers of stock are injured if they buy without knowl edge of the proposed stock watering, and the bond buyer 48 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III is injured if the watering of the stock, having given him a false idea of the actual capital, induces him to lend more money than the capital can satisfactorily Secure. $ 5. Insolvency The original capital of a concern may be either increased or decreased. It may even disappear altogether if the assets shrink so much as no longer to exceed the liabilities (other than the capital liability itself). Insolvency is the condition in which the assets fall short of the liabilities other than capital. The capital-balance is intended to prevent this very calamity; it is for the express purpose of guaranteeing the value of the other liabilities — those to bondholders and other creditors. These other liabilities, for the most part, are fixed blocks of property, carved, as it were, out of assets, the value of which property the merchant or company has agreed to keep intact at all hazards. The fortunes of business will naturally cause the whole volume of assets to vary in value, but all the “slack ’’ ought properly to be taken up or given out by the capital, the surplus, and the undivided profits. A man's capital thus acts as a safety fund or buffer to keep the liabili ties from overtaking the assets. It is the “margin'” he puts up as a guarantee to others who intrust their capital to him. - The amount of capital-balance necessary to make a busi mess reasonably safe will differ with circumstances. A capi tal-balance equal to five per cent of the liabilities may, in one kind of business, such as the business of a mortgage company, be perfectly adequate, whereas fifty per cent may be required in another kind. Much depends on how likely the assets are to shrink, and to what extent; and much, likewise, depends on the character of the liabilities. The risk of insolvency is the chance that the assets may shrink below the liabilities — to others than stockholders. Sec. 5) CAPITAL 49 This risk is the greater, the more shrinkable the assets, and the less the margin of capital-value between assets and liabilities. Insolvency must be distinguished from insufficiency of cash. The assets may comfortably exceed the liabilities, and yet the cash assets at a particular moment may be less than the cash liabilities due at that moment. This condi tion is not true insolvency, but only insufficiency of cash. In such a case, a little forbearance on the part of creditors may be all that is necessary to prevent financial ship wreck. A wise merchant, however, will not only avoid insolvency, but also insufficiency of cash. He will not only keep his as sets in excess of his liabilities by a safe margin, but he will also see that his assets are invested in such a manner that he shall be able, by exchanging them for cash, to cancel each claim at the time and in the manner agreed upon. From this point of view there are three chief forms of assets; namely, cash assets, quick assets, and slow assets. A cash asset is in actual money, or what is acceptable in place of money. A quick asset is one which may be exchanged for cash in a relatively short time, as, for instance, gold or silver bullion, wheat, short-time loans, and other marketable se curities. A slow asset is one which may require a relatively long time to be exchanged for cash. Such are real estate, office fixtures, and manufacturers’ equipment. If all property were as acceptable as money, there would be no need of classifying assets into these three groups. But since the creditor will not accept railwaystock or bonds, when he has contracted for payment in money, the debtor must maneuver so as to keep on hand a sufficient quantity of cash assets to enable him to meet his immediate obli gations and enough quick assets to enable him to exchange them for cash in time to meet obligations soon to fall due. A large part of the skill of a business man consists in marshal ing his assets so that he always has enough cash and enough E 5o ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III quick assets to provide for impending debts, while maintain ing at the same time enough slow assets to insure a satis factory income from his business. Originally, before business was separated from private life, all of a debtor's assets, even including his own person, were regarded as pledged to the payment of a debt. An insolvent debtor could be imprisoned. To-day, however, laws exist in most countries by which a bankrupt may, under certain conditions, be discharged, free from further liability. Since the liabilities of one man are also the assets of another, when one man fails and is able to pay only fifty cents on the dollar, the unlucky man who is his creditor – who has the first man's notes as assets – suffers a shrinkage in his own assets which may in turn mean embarrassment or even bankruptcy to him. It is usually true in a panic that the failures start with the collapse of some big firm, involv ing a shrinkage in the assets of others. This indicates why assets ought usually to be undervalued. A man who is in debt has no right to exaggerate his means of payment. A conservative and honest business man will always under value rather than overvalue his assets, in order to be fair to his creditors. § 6. Real and Fictitious Persons It is well to note here the distinction between the account ing of real persons and of fictitious persons. For a real per son, the assets may be, and usually are, in excess of the liabilities, and the difference is the capital-balance of that person. This capital is not, in the case of real persons, to be regarded as a liability, but as a balance or difference between the liabilities and the assets. For a fictitious person (i.e., a corporation, partnership, association, etc., regarded as independent of the real persons comprising it), on the other hand, the liabilities are always exactly equal to the assets; for the balancing item called capital Sec. 7] CAPITAL 51 is as truly an obligation (from the fictitious person to the real stockholders) as any of the other liabilities. For instance, the items entered as “capital,” “surplus,” and “undivided profits” in the accounts of a joint stock company do not belong to the company, as such, but to the stock holders. So far as the “company ” is concerned, they are its liabilities; they represent what it owes to the stockholders, just as truly as the other items of liabilities represent what it owes to the bondholders, etc. A fictitious person, in fact, is a mere imaginary being, holding certain assets and owing all of them out again to real persons, including the stock holders. A joint stock company may, it is true, be re garded as consisting of real persons (stockholders, etc.). But if we prefer, it may be regarded as a separate entity. In this case, of course, the “company ” becomes a mere bookkeeping dummy having no capital-balance of its own and apart from what it owes the stockholders. § 7. Two Methods of Combining Capital Accounts We have seen how the capital account of each person in a community is formed. Our next task is to express the total net capital of any community. This is the sum of the net capitals of its members, i.e., all the innumerable assets of all the persons less all the liabilities of those persons. This net sum will be the same, of course, in whatever order the items are added and subtracted. We might write each item on a slip of paper, marking each asset item as positive and each liability item as negative, and, shuffling them into any ran dom order, add and subtract them one by one according as they are positive or negative. But there are two ways in particular which need to be emphasized. The simplest is, first, to obtain the net capital-balance of each person by subtracting the value of his liabilities from that of his assets, and then to add together these net capitals of different persons to get the capital of society. This 52 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. III method of obtaining society's net capital may be called the method of balances; for we balance the books of each indi vidual. The other method is to cancel each liability against an equal and opposite asset, which equal and opposite asset, as we shall see, must exist somewhere in another individual's account, and then add the remaining assets. This method may be called the method of couples; for we couple items in two different accounts. The method of couples is based on the fact that every liability item in a balance sheet implies the existence of an equal asset in some other balance sheet. This is true because every debit implies a credit. A debt may be owed to somebody, a creditor, as well as from somebody, a debtor, and the debt of the debtor is the credit of the creditor. It follows that every negative term in one balance sheet may be can celed against a corresponding positive term in Some other. Each of these two methods—of balances and of couples — is important in its own way. Let us illustrate each by the balance sheets of three real persons, say X, Y, and Z. PERSON X ASSETS LIABILITIES Z's note . . . . $30,000 A Residence . . . . 7o,ooo Railroad shares . . 20,000 $120,000 Capital-balance . $70,000 Mortgage held by Y. $50,000 b $50,000 - PERSON Y ASSETS LIABILITIES X's mortgage . . . $50,000 B Personal effects Railroad shares . . Capital-balance . 20,000 Io,000 $80,000 . $40,000 Debt to Z . . . . $40,000 c . . $40,000 Sec. 7] 53 CAPITAL PERSON Z ASSETS Y’s debt . . Farm . . . Railroad bonds Capital-balance LIABILITIES . . . $40,000 C 50,000 20,000 $1 Io,000 . $80,000 Debt to X . . . $30,000 a $30,000 As the persons are real, not fictitious, the “capital” is in this case not a true liability, but is the excess of the total assets over the total liabilities. The sum of these capital-balances is the total net capital of X, Y, and Z, and is thus obtained by the method of balances. To show the method of couples in the table, each couple of corresponding items—i.e., each item which appears twice, once as a liability of one man and again as an asset of another — is indicated in both places by the same letter. Thus, “A ’’ in X's assets is matched by the equal and opposite item “a " in Z's liabilities. The method of couples thus consists in canceling, and, therefore, omitting from society's balance sheet, these pairs of items, and entering and adding only those which remain uncanceled. These, in the present case, are all assets. Adding these, we again obtain a sum representing the total net capital of X, Y, and Z, this time by the method of couples. The results of summing up the capital accounts by the two methods are shown in the following tables:– METHOD OF BALANCES X's capital Y’s capital Z's capital . . . . . . . . . . $70,000 . 40,000 . 80,000 $190,000 METHOD OF COUPLES Residence . . Personal effects Farm . . . Railroad shares Railroad bonds . . . $70,000 . . . 20,000 . . . 50,000 . . . 30,000 . . . 20,000 $190,000 The totals are the same by both methods, but the method of balances exhibits the share of this total capital which is 54 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. III owned by each individual, while the method of couples ex hibits the portion ascribable to each different capital-good. §8. Ultimate Result of Method of Couples Let us now introduce into our addition the capital ac counts of the railroad whose stocks and bonds were included among the assets of persons X, Y, and Z. For simplicity, we shall suppose that these three persons are the only persons interested in the road. The balance sheet of the railroad company will accordingly appear as follows:– RAILROAD COMPANY ASSETS Railway . . . LIABILITIES . . $50,000 Bonds (held by Z) . . $20,000 Capital stock (held by X) $20,0oo (held by Y) $10,000 $50,000 Capital-balance of the R.R. Co. itself $oo,ooo 3o,Ooo $50,000 If now, by the method of balances, we combine this balance sheet with those of X, Y, and Z, we shall see that its inclu sion does not affect the results which were obtained by the same method before the railroad was introduced into the discussion. The totals will stand as follows: — X's capital-balance. Y’s capital-balance . Z's capital-balance . . . . . . . . . . . . . . . . . . . . . . $70,000 40,000 80,000 Railroad Co.'s capital-balance . . . . . ooooo $190,000 When we apply the method of couples, we find, however, that the inclusion in our consideration of the railway company's capital account will affect the items, though not the final sum. The stocks and bonds, as assets of X, Y, and Z, will then pair off or couple with the corresponding liabilities of the railroad company, and their place will be taken by the concrete railroad itself, as follows:– Sec. 8] 55 CAPITAL METHOD OF COUPLES Residence . . . . . . . . . $70,000 Personal effects. . . . . . . . 20,000 Farm . . . . . . . . . . . 50,000 Railway . . . . . . . . . . 50,000 $190,000 The appearance of the capital inventory is thus changed. Formerly, the items of property rights in it included such part-rights as stocks and bonds; now they consist only of complete property rights. But the complete right to any article of wealth is best expressed in terms of the article of wealth itself. Consequently, instead of the long phrase, the “right to a residence,” we may merely use the term “residence.” The property no longer veils the wealth be neath it; and the inventory, which before was an inventory of both capital wealth and capital properly becomes an in ventory of only capital wealth. Such a result is sure to follow when we combine capital accounts, provided we combine enough of them to supply, for every liability item, its counterpart asset, and for every asset which has one, its counterpart liability. Those assets which have no counterparts are what we have called the complete rights to wealth; while those assets which do have canceling counterparts are the partial rights to wealth. The reason is that partial rights to wealth necessarily have canceling counterparts in that whenever any partial ownership of a given article of wealth is held by a partic ular person, its whole ownership must be supposed to be held by some fictitious person even if specially created for the purpose. Thus, if a farmer named Smith owns an un divided half interest in a farm jointly owned by himself and brother, we conceive of the whole farm as owned by the fictitious person, the partnership, known as the “Smith brothers.” The owner of the half interest, “John Smith,” thus holds a claim against the partnership “Smith broth ers.” This claim is an asset to Smith but a liability to the 56 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. III partnership. It is clear that an individual cannot own a part interest in any given, wealth without its being true that the fictitious owner of it all is liable to him to that extent. Therefore every partial right to wealth, while an asset to the owner of that right, is a liability to the ficti tious person owning the whole. Every article of concrete wealth has to be regarded as owned by some one, even if we have to set up a fictitious person or dummy for that very purpose. To follow out totals of capital thus requires the inclusion of many fictitious persons, for it is often only the fictitious persons who hold the complete rights. Locomotives and railway stations, for instance, are owned by corporations, not individuals. In fact, these fictitious persons — partner ships, corporations, trusts, municipalities, associations, and the like — are devices for the express purpose of holding large aggregations of concrete wealth and parceling out its ownership among a number of real persons. If, then, we suppose balance sheets so constructed as to include all the real and fictitious persons in the world, with entries in them for every asset and liability, - even public parks and streets, household furniture, and other possessions not formally accounted for in ordinary practice,—it is evi dent that we shall obtain, by the method of balances, a complete account of the distribution of capital-value among real persons; and, by the method of couples, a complete list of the articles of actual wealth thus owned. In this list there will be no stocks, bonds, mortgages, notes, or other part-rights, but only land, buildings, and other land improve ments, and commodities. All debit and credit items being two faced — positive and negative — cancel out in the total. This self-effacement, however, does not mean that the total would be just the same if there were no stocks, bonds, mortgages, notes, or other two-faced items. On the con trary, the existence of such property rights indirectly adds a great deal to the effectiveness of wealth. They make SEc. 9] CAPITAL 57 possible the coöperative ownership of great aggregations of capital which without such ownership could scarcely exist, and thus result in increasing greatly the total bene fits we enjoy from capital. § 9. Confusions to be Avoided Among the forms of part-rights in real wealth is “credit.” Credit is simply a debt looked at from the standpoint of the creditor. of credit. There has been much discussion as to the nature It has been sometimes regarded as an item of wealth; and an increase or inflation of credit has been looked on as a real addition to the wealth of the commu nity. But, of course, since every credit is also a debit, it cannot be regarded as a simple addition to the wealth of the community as a whole. The phenomenon of credit means nothing more nor less than a specific form of divided ownership of wealth. Credit merely enables one man temporarily to control more wealth or property than he owns – i.e., some part of the wealth or property of others. It is, therefore, a cardinal error to regard credit as increas ing the capital of the debtor. Indirectly, of course, credit may result in an increase of society's capital, by stimulating trade and production, as well as by getting the management of capital into the right hands and its ownership into the most effective form. In these ways the earth is made to yield up more wealth, or greater benefits from the same wealth — in either case entailing an increase of capital; but the amount of any such increase of capital thus indirectly produced bears no necessary relation to the amount of the credit which facilitated its production. Even when capital is increased through credit, the credit does not constitute the increase. A great deal of confusion in legislation and discussion could be avoided if the two methods of combining capital accounts were distinguished and their interrelations recognized. In taxation, the two methods are often confused. An impor 58 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. III tant problem of efficient taxation of property is how to avoid unintentional double taxation and at the same time not to allow some property unintentionally to escape any taxa tion. There are two solutions. One is to tax the amount owned by each real person as obtained by the method of balances; this method seeks out the real owners or part-owners of wealth. The other is to tax the actual concrete wealth as obtained by the method of couples; this method seeks out the real wealth owned. In short, one method follows the person, the other the thing. At present the two methods are much confused. Legislators too often fail to perceive that under the first, or owner method, corporations should not be taxed, for they are not true owners; and that under the second, or wealth-method, bonds, stocks, and other part-rights to wealth should not be taxed, for these are already taxed when the actual rail ways and other items of physical wealth underlying such part-rights are taxed. It is not claimed, of course, that a complete system of taxation can be worked out merely by choosing one of the two methods just indicated. But the distinction between the two should be borne in mind, when ever any scheme of taxation is considered; for where one system is applied, the other cannot also be applied without double taxation. The study of capital accounting, therefore, enables us to avoid many common confusions. More important still, it gives us a clear picture of the relations between the capital of a community and the capital of the individuals of which the community is composed, i.e., between the stocks of actual wealth in a community and the stocks of property representing the ownership of this wealth among different individuals. In short, it enables us to see both individually and as a whole the items which make up private and collective property, as stocks, bonds, mortgages, debts, etc., on the one hand, and land, ships, dwellings, and other concrete wealth, on the other. SEc. 9] CAPITAL 59 In the light of the foregoing principles we are in a position to take a bird's-eye view of the capital in any country. In America, for instance, we find a stock of wealth of various kinds with an estimated value of over $100,000,000,ooo. More than half of this consists of real estate; about ten per cent consists of railways and their equipment; manu factured products make up about $8,000,000,ooo; furniture, carriages, and kindred articles about $6,000,000,ooo; live stock on farms about $4,000,000,ooo; tools, implements, and machinery in factories about $3,000,000,ooo; clothing and personal adornments about $2,500,000,ooo; street railways about $2,000,ooo,ooo; agricultural products about $2,000,000,ooo; gold and silver coin and bullion about $2,000,000,ooo; and there are numerous other smaller items. The ownership of this real wealth is divided up in various ways. To a very large extent, especially in the case of farms, the real estate is owned completely by the occupier. In other cases it is mortgaged, the occupier then owning merely the excess of value over the mortgage. Of the national capital apart from real estate, on the other hand, probably by far the greater part is owned by corporations, which means, of course, simply that its ownership is parceled out among the stockholders and bondholders of these corporations. From what has been said the student will not make the mistake of adding the value of stocks and bonds to the value of the tangible wealth which these represent. Stocks, bonds, mortgages, and other items which are assets to some persons are liabilities to others, and thus cancel themselves out for the country as a whole. The student will also notice how insignificant is the stock of gold and silver as compared with the total capital, although the value of all is measured in terms of gold. CHAPTER IV INCOME § 1. Concepts of Income and Outgo THE income from any particular article of wealth has been defined as the flow of benefits from that article. These bene fits may sometimes consist of money payments; but it is important to avoid the mistaken notion that they always consist of money payments. (Income is the flow of whatever benefits accrue from any article, whether these benefits happen to be in the form of money payments or not) A self supporting farmer, for instance, may not receive or expend a single dollar from one year's end to the other. He has, nevertheless, an income. He gets a “living ” — the very essence of income — from the farm. A windmill pumps water; the pumping is the benefit or income resulting from the windmill. A derrick hoists coal from a mine; the hoist ing is the income from the derrick. A wife does housework; her work is an item of the family's income, for, as was stated in the last chapter, the services of a human being are income. The warmth and shelter that a house provides for its occupants constitute the income furnished by the house. All the operations of industry and all the transac tions of commerce are items of income. When axes fell trees and sawmills turn them into lumber, these changes constitute items in the income flowing from the agencies which produce them. When a manufacturing plant con verts raw materials into food or into fabrics or into imple6o SEc. 1] INCOME 61 ments, these changes constitute income produced by the plant. What we call agriculture, mining, commerce, and domestic operations constitute large and important classes of income. Practically, of course, most of the examples given of bene fits or services are not income to the owner of the instru ments rendering those services; for, practically, those services are not enjoyed by the owner, but are sold to some one else, the owner receiving a money payment instead. Thus, although a farmer may get his living directly from the farm, it is more usual for him to sell some of the farm products and to receive money payments instead. Likewise it may be that the owner of the windmill pumps water for others and receives money payments in return; and that the owner of a house sells its use for a money rental. Simi larly the owners of the derrick, axes, sawmill, manufacturing plant, etc., do not get the direct benefit of the hoisting, cutting, sawing, manufacturing, etc., but exchange these for money payments. In such cases the owners get their in come in the form of money payments by selling to others the direct benefits of their capital. Thus their capital yields them an indirect money income through the sale of the direct income produced by the capital. So usual is it for the owner of capital to sell his direct or natural income for a money income that ordinarily we think of income as consisting only of such money return. One of the early economists seri ously maintained that the owner of a house could receive no income from it except by renting it, forgetting that to let a house is merely to sell the shelter income for money income. A man who lives in his own house gets the shelter income directly. A man who lets his house to another secures a money income as the equivalent of the shelter in come which he sells to the tenant. Income, being a flow of benefits, implies a stock or fund which produces the flow. This stock or fund may consist partly of instruments of external wealth, which we have r 62 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. IV designated as capital (in the narrow sense), and partly of the population itself, which is also capital (in the broader sense). It has already been noted that income differs from capital in two respects. In the first place, income is a flow relating to a given period, whereas capital is a stock or fund relating to a given instant. In the second place, income consists of (intangible) benefits, whereas capital consists of (tangible) instruments; not farms, therefore, nor houses, nor food, nor railroads, nor artesian wells, nor instruments of any sort can, strictly speaking, ever constitute income. Income consists rather in the yielding of crops by the farms; the warming and sheltering of people by the houses; the nourishing of people by the food; the transporting of passengers and freight by the railroads; the raising of water by the wells; and benefits of any sort rendered by instruments of wealth. Although income consists partly of other benefits than money receipts, all income, like all capital, may be translated into terms of money. For, as was pointed out in chapter II, § 1, to all items of income, i.e., benefits, may be applied the concepts of price and value. Income, as well as capital, is subject to accounting. Thus far we have considered only such items as would belong to the positive side of income accounts. But just as in our capital account we found a negative side — com prising the liabilities — so we shall find a negative side to income. The negative of income is called outgo, and the items which constitute outgo are called costs. A cost occasioned by an article has already been defined as the opposite of a benefit. It is an undesirable event occa sioned by that article. Labor, trouble, expense, and sacri fices of all sorts are entailed by wealth and are counted among its costs. An instrument seldom confers benefits without also involving costs. A dwelling, while it gives shelter, compels its. owner to assume important costs in keeping it in repair, painting it, cleaning it, caring for it, - SEc. 1] INCOME 63 insuring it, and paying taxes upon it. A saddle horse yields income to the owner when it gives him a pleasure ride, but it requires feeding, stabling, and shoeing — the negative side of the account, constituting the outgo or flow of costs oc casioned by the horse. A farm produces benefits in yielding crops; but it requires fertilizing, tilling, and seeding, all of which are costs occasioned by the farm. A railroad pro duces benefits called “transportation” – hauling passengers and commodities; but it involves an expenditure of money, it burns coal, it requires labor; and these are the outgo, or the negative side of its account. Costs, too, may be measured in money just as income may be measured in money; and some costs, whether of dwel lings, farms, railways, or other articles, consist in the actual expenditure of money, just as some benefits consist in the receipt of money. Strictly speaking, neither consists of actual money. We must, therefore, distinguish carefully three money items: (1) money on hand at an instant of time, which is an example of capital; (2) the receipt of money during a period of time, which is an example of income (from whatever instrument occasions the receipt of the money); and (3) the expenditure of money during a period of time, which is an example of outgo (on the part of whatever instru ment occasions the expense). In general, the costs of a given item of capital are out weighed by its benefits. For if it should occasion more costs than benefits, it would be thrown away, thereupon ceasing to be wealth according to our definition. Or if it should still remain in any one's possession, it might be called negative wealth, of which ashes, rubbish, garbage, etc., are familiar examples. Costs, then, are never voluntarily assumed except in the hope of benefits which will make them worth while. The total value of all the benefits flowing from a given instrument in a given time is called gross income-value or simply gross income, during that time. Similarly, the total value 64 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. IV of its costs is called outgo-value or simply outgo. The total gross income during a given time minus the total outgo (i.e., the value of its costs), constitutes net income. Thus, just as net capital is found by subtracting the lia bilities from the assets in a capital account, so net income in an income account is found by subtracting the value of the costs from the value of the benefits. Both benefits and costs, moreover, are attributable to a definite capital source. In income-accounting the benefits or income-items are credited to capital, and the outgo or cost-items are debited to capital. In keeping income accounts, therefore, it is important to know to what category of capital any item of income should be credited, or any item of outgo debited. § 2. Income Accounts We are now in a position to apply the foregoing definitions to income accounts. Perhaps no other subject in economics has been so fraught with confusion, misunderstanding, and double counting, as income. It will help the student to understand these accounts if he will bear in mind that they show the income and outgo which any given capital (or free human being) yields. We are apt to think of income and outgo too much with reference to the owner of the income instead of the source of the income. It will be easy later to make up the owner's income account; but first we must construct the income account for an isolated article of capital. We may begin by imagining a certain “house-and-lot ” as one composite instrument or article of wealth, and may first consider its income and outgo during the calendar year 1910. The instrument is capital, and the income which this capital brings to its owner may be either a money rental or the direct shelter and similar benefits of the house enjoyed by himself and his family. In either case the income may be measured in money, although in the case of occupancy by the owner this measurement requires a special appraise r Sec. 2) 65 INCOME ment. The house, let us suppose, was built many years ago, and is now nearly worn out. It yields an income worth $1ooo a year. Against its income there are offsets in the form of repairs, taxes, etc. — costs which it occasions. We have, then, the following “income account ’’: — INCOME ACCOUNT FOR HOUSE AND LOT DURING THE YEAR 1910 OUTGO INCOME Use of house and lot . . $10oo Repairs Taxes . . . . . . . $200 . . . . . . 180 Insurance . . . . . . . 20 Net income . . . . $4oo $1ooo $600 Next year the house is found to have rotten timbers, is condemned, and must be abandoned or torn down. Its benefits are ended, but the land is still good, and the owner can build a new house. The period consumed by this opera tion is the first six months of the year 1911, so that during such period there is no income attributable to the house and lot, but only outgo. During the second half of the year the house is occupied, and its use is valued at $600. In the first six months not only did the “house-and-lot ” fail to yield any income, but it occasioned a cost. This cost was the cost of production of the new house. We have, then, the following account: — INCOME ACCOUNT FOR HOUSE AND LOT DURING THE YEAR 1911 INCOME OUTGO Use of house and lot (six months). . . . . . $600 _ Expense house of building . . . . . $10,000 Taxes and insurance . $600 Net outgo. . . . . Ioo $1o, Ioo $9,500 During this year, then, the house causes a net outgo of $9500. As we know, all costs are “necessary evils’’; they F 66 ELEMENTARY PRINCIPLES OF ECONOMICS ICHAP. IV lead to good, though not good themselves; and this cost of constructing the house was incurred only for the sake of expected future benefits. The adverse balance it creates is only temporary, and should be more than made up in the years which follow. For the year 1912, for instance, we may have the follow Ing: — INCOME ACCOUNT FOR HOUSE AND LOT DURING THE YEAR 1912 INCOME Use . . OUTGO . . . . . $1300 Net income . . . . Repairs . . . . . Taxes and insurance . $130.o . . $ 50 . .25o $300 $10oo These figures remain about the same for forty-nine years and give $49,000 net income during that time, offsetting the 1912 to 13 1914, 1915 is 16 is ir 1918 19te tezo INcome shelter ouTGO repairs etc. excess in cost for 1911 ($9500) and leav ing a large margin besides. Then the house is worn out a second time and has to be rebuilt. The same cycle is repeated, one year of excess of cost being offset by forty-nine years of excess of income. Figure 2 shows a part of this cycle, picturing graphically the figures in the above income-and-outgo accounts. It will be observed that the cost of reconstructing the house was entered in the accounts in exactly the same way as the cost of repairing it or as any other costs. This may SEC. 3] INCOME 67 be puzzling at first, because most of the other costs are fairly regular year by year, whereas the cost of reconstruc tion occurs only once, or at any rate only once in a long while. It may also seem puzzling because the cost of reconstruc tion is so large in comparison with other costs. But the irregularity or size of costs is, of itself, no reason for omitting them from our accounts. The only way in which we can escape recording such a cost– for instance, the cost of constructing the house – is by substituting in its place an equivalent series of smaller and more regular costs. What is called a depreciation fund is sometimes created for this very purpose. This fund is accumulated during the exist ence of the house by setting aside annually small portions of the income yielded by the house, sufficient in the aggre gate to replace the house when it is worn out. The depreci ation fund, combined with the “house-and-lot ” renders the flow of costs uniform or regular. But even when a depreciation fund is used, we can only say that the com bination of the two things (the fund and the house) has a regular cost. We cannot say that this is true of the house by itself; and when no such device as a depreciation fund at all is used, there can be no escape from charging the cost of reconstruction in precisely the same way as we charge any other cost. If this still seems puzzling, it is because we are in the habit of seeing the cost of reconstruction entered as the value of the house and, hearing it called, for that reason, a “capital cost.” It is true that the value of the new house must be entered on the capital-balance sheet; but the cost of producing it belongs properly to the income ac count. The value relates to an instant of time (which may be any instant from the time the house is begun till the time when it ceases to exist); the cost relates to a period of time (which may be all or any part of the time during which the labor and other sacrifices occasioned by the house occur). The value of the house is quite distinct from the series of costs by which it was built, although the confusion 68 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. IV between the two is natural in view of the bookkeeping practice of entering capital at its “cost value.” The house on which $10,000 was expended for construction may be worth either more or less than $10,000. In either case the income account should contain $10,000 on the outgo side, and the capital account a larger or smaller figure, as the case may require. § 3. Devices for Making Net Income Regular We have seen that the irregularities in the net annual income or outgo flowing from the “house-and-lot” may be combined with the opposite irregularities of the net an nual outgo or income from a “depreciation fund,” so that the net result from the two combined is a steady net in come. . The same result may be secured in other ways. For instance, if the owner of the house-and-lot happens to own a large number of other houses-and-lots in different degrees of repair, the irregularities in income from them in dividually may tend to offset each other. Thus, if a man owns fifty houses, each lasting fifty years, and every year one wears out and has to be rebuilt, it is then evident that he will have an expense of $10,000 every year for the rebuilding of a house, which will be a regular item; and he will have a regular income balance as a consequence, because he will get the benefit of forty-nine houses, which will far outweigh the cost of building only one. The differ ence will be his net income, which will be a fairly regular amount year after year. This example ought to set at rest any lingering doubts as to the correctness of our including the cost of recon structing a house as an item of outgo, to be entered as such in a true and complete income account. The only reason this may, at first, seem wrong is that the cost of reconstruction is not usually a regular item. In the case of the fifty houses it becomes a more or less regular item. - SEC. 4) 69 INCOME But if it is correct to call it outgo when there are fifty houses, it must be correct to call it outgo when there are ten houses or when there is only one. Irregularity of in come is an inconvenience and we usually seek to avoid it by depreciation funds, by having a large number of articles at different stages of repair, or otherwise. But so long as irregularity of income exists it must be entered as such. The effect of reducing irregularities by combining a large assortment of articles is present wherever a sufficiently large assortment exists. Professor Clark of Columbia Uni versity suggests a helpful simile when he compares a stock or fund of capital to a waterfall: the drops of water, or component parts of the waterfall or fund, are constantly changing; but the waterfall or fund remains substantially the same. - § 4. How to Credit and Debit Before leaving the subject of income accounts, we shall speak of one particular kind of capital, namely, a stock of cash. This will furnish an opportunity to illustrate anew some of the principles of accounting which we have just dis cussed. What puzzles the novice in accounting is the manner of debiting and crediting a stock of cash, or what is called the “cash drawer.” At first sight the usage seems to be the opposite of what it should be. To understand the practice of accountants in this particular is to go a long way toward understanding the main principles of accounting. It will help us to understand it if we liken a cash drawer to a gold mine. We credit a gold mine with all the gold extracted, and we debit it with all the costs put into it. In the case of the gold mine, what it costs to run it is outgo; all of the yield of gold is gross income; and the difference is the net income. Similarly, the gross income from the cash drawer consists of what the cash drawer yields, or whatever comes out of it. It benefits us whenever it pays our bills; it costs us whenever we pay its bills, i.e., whenever we pay some 7o ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. IV thing into it. All the payments which we have to make to the drawer are a cost of that drawer to us, whereas all the payments that we make by the drawer are the benefits which it produces for us. As long as we pay money into the drawer, we realize no income, but merely accumulate capital for future use. If we should only pay money into the drawer and never throughout our life take any out, the “drawer" would benefit us nothing. Its benefits would go to our descendants whenever they should take the money out. Ordinarily, however, the money is taken out soon after it is put in. What met benefit, then, does the cash drawer yield in the long run? Seldom anything at all. We pay out just as much as we put in; and if we subtract one amount from the other, the net annual income from the cash drawer will be about zero, unless during a certain year we store up more than we take out, or take out more than we put in. The reason that these credits and debits of “cash ’’ seem at first the reverse of what they should be is that we are ac customed to think of money receipts and expenditures, not in their relation to the stock of cash into or out of which they are paid, but in their relation to some other item of wealth on account of which the payments are made. If a lodging house keeper receives $10 from a lodger and puts it into her cash drawer, she finds it hard to debit $10 to “cash.” She thinks of the $10 as income; and it is income with respect to her lodging-house, for the latter has yielded it to her. Her stock of cash, however, has not yielded the $10 to her. On the contrary, it has taken that amount from her. Later on it will yield back that amount or some portion of it, and at that time may properly be credited with the sum it yields up. We are now ready to understand how to derive a man's total income. It is simply the combined income from all the capital he owns. We could obtain a full account of it by keeping a separate income account for each item of capital he owns, crediting and debiting each such item with its re SEC. 4) 71 INCOME spective benefits and costs. The difference of all the benefits and costs of all his capital is his net income. In these accounts we should include, therefore, all positive and nega tive items of income pertaining to all positive and nega tive items of capital. The negative items of capital are the liabilities. Liabilities yield a net outgo instead of a net income. In order, then, to find out the net income of any person during a certain day or month or year, the proper method is to make a complete statement of all his assets and all his liabilities; and for each asset as well as each liability, credit all the benefits and debit all the costs. The net result will be the net income of the person. A real person will have a net income, but a fictitious person will not. We have seen, in the case of fictitious per sons, that there is no net capital because the liabilities always equal the assets; for what is often called the capital of a “company” really means the capital of its stockholders. As there is no net capital of the company, as such, the “com pany ” owing it all to the stockholders, so there is no net income of the company, as such, the “company ” paying it all to the stockholders or others. The following is an imaginary income account of a rail road company: — INCOME ACCOUNT OF A RAILROAD CORPORATION INCOME By passenger and freight service . OUTGO $1,246,147 To operating expenses $8oo,ooo To interest to bond holders . . . . Ioo,ooo To dividends to stock holders . . . 200,000 To surplus applied to (1) purchase of land (2) cash paid into treasury . $1,246,147 . 140,000 . 6,147 $1,246,147 72 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. IV The passenger and freight service has yielded $1,246,147. That is the gross income of the road. All the benefits flowing from that road are worth this amount of money. On the other side of the railroad account we find the costs of the road to the company; they exactly equal the benefits, for the company is an abstraction – a mere holding concern — not a real individual. The outgo consists principally of operating expenses, $800,000; interest to bondholders, $100,ooo; dividends to stockholders, $200,000. The words by and to are usual in income accounts. The receipts are benefits; they come by virtue of the services designated. The costs represent something which has to be given to these several items in order to make the benefits possible. These items leave a surplus, part of which is expended for land ($140,000); this is a cost just as much as anything else. Then there is cash left in the treasury to the amount of $6147. It must not be concluded that this cash is a net income. The cash drawer swallows it up. The company loses $6147, so to speak, in feeding its cash drawer. There fore the two sides of the account balance, and there is no net income at all to the “company.” § 5. Omissions and Errors in Practice Practically, however, it is not convenient to enter in an income or a capital account everything which theoretically ought to be entered there. Moreover, capital and income accounts are not always treated consistently in practice. For instance, in a capital account a man would not ordi narily enter his own person, as a free human being is not ordinarily counted as wealth; and yet in his income ac count he will enter the money he earns or the work that he does. That is, work and wages are entered in the income accounts, but the corresponding items representing the agencies which do this work or earn these wages are not entered in the capital accounts. The correspondence be SEC. 5) INCOME 73 tween the two accountsis, therefore, obscured. On the other hand, a man never, in practice, enters in his income account the shelter of his own house as a benefit, and yet he may include the house among his assets in his capital account. In ideal accounting we should insist upon recording every benefit of any kind, every cost, and every source of benefit or cost. As we have already indicated, an early economist fell into error when he said that a dwelling occupied by the owner yields no income. He claimed that, on the contrary, it is a source of expense. Evidently he had in mind only those costs and benefits which come in the form of money payments. One certainly gets no money benefits by living in his own house, while he does suffer a money cost to run it. So far as money receipts and expenditures are concerned, therefore, the house costs more than it brings in. But no man would keep his house if it did not afford him benefits greater than its costs. We should, therefore, appraise the shelter of the house and enter this as its gross income. If we do not, we reach the absurd conclusion that if I live in my own house and you live in your own house, neither of us receives any income; but if you rent your house to me and I rent mine to you, then we shall each be receiving income ! Obviously the income is really there, all the time, in the form of shelter; and when one man rents another man's house, he gets the shelter-income and gives the other man a money-income in its place. An account of money received and expended by a given person can sometimes furnish a fairly complete picture of his income; but only when two conditions exist; namely, that all the income from his property is in the form of money, and all the outgo is in the form of money spent for personal satisfactions (i.e., goes directly to pay for clothes, food, shelter, amusements, and the like, and is not expended in investments, repairs, and the expenses of run ning a business). Under these conditions the cash drawer and the cash account constitute a kind of money meter of 74 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. IV income. These conditions are approximately fulfilled when people live in a city and rent the houses or furniture of others instead of owning them themselves. Such people get practically all of their income in the form of money receipts, as salaries, dividends, and interest. This money is spent for benefits, as food, clothing, theater going, etc. The cash drawer (or bank account) then intervenes be tween the money-income on the one hand, and the final income which this money-income buys, on the other hand; much as a cogwheel intervenes to transmit motion from one part of a machine to another. A man who receives $5000 a year in money or checks and spends it all on food, clothing, shelter, amusements, and other final or enjoyable benefits, and gets no such benefits from any other source, evidently receives a real income of $5000 a year. His money income correctly measures his real income. But if he “saves” part of the $5000, i.e., ex pends it for stocks, bonds, or a savings bank account or any other capital, the benefits from which are greatly de ferred, his real income may be less than $5000; while if he derives shelter from his own house, or food from his own garden, his real income may be greater than his money income. Thus money income is an unsafe indica tion of real income. The only method, then, of construct ing income and outgo accounts which will be correct and which can serve as a basis for economic analysis is the method already indicated — the method by which are re corded, for each article of capital (including human beings), the values of all its benefits and all its costs. These benefits and costs are of many kinds. Sometimes they consist of money payments — not in themselves enjoyable to anybody; sometimes they consist of merely intermediate or produc tive operations; and sometimes, of truly final or enjoyable elements. All these items should be entered in the accounts on the same footing; but we shall see that all except the “enjoyable ’ elements will cancel among themselves. CHAPTER V COMBINING INCOME ACCOUNTS § 1. Methods of “Balances” and “Couples” “Interactions ' WE have now learned how to reckon the income of either a real or a fictitious person. Of reckoning the income of all society, on the other hand, there are many ways, including, in particular, two that correspond to the two ways which we discussed in Chapter III of reckoning society's capital. These are the method of balances and the method of couples. The method of balances is very easy to apply. All that is necessary is to make up an income account for any given period for each instrument or article of wealth so as to include all possible income or outgo in society and, de riving from each such account the net balance, add these net balances together. The result is the total income of society. Its constituent parts are the net incomes from the several articles of society's wealth. The “method of couples’’ is somewhat more difficult to follow. But it is also more important. Just as it often happens that the same item in capital accounts is both asset and liability, according to the point of view, and is therefore self-canceling, so it often happens that the same item in income accounts is both benefit and cost, and is, therefore, likewise self-canceling. In fact, the reader may have felt that, in many of the examples cited, what we called costs were really benefits. He may have asked himself: Why 75 76 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. V should we call repairing a house a cost? When a carpenter and his tools repair it, do we not credit him and them with a service performed? Is not any production a benefit? Have we not, then, placed repairs on the wrong side of the ledger? It all depends upon which of two accounts we are considering. When a carpenter with his plane, hammer, and saw helps to rebuild a house, we have to consider two groups of capital." One group, the carpenter and tools, is acting on the other group, the house. The carpenter and tools cer tainly perform a service or benefit, but the house does not. Considered as occasioned by the house, the repairs are costs. The house absorbs or soaks up these costs, promising to com pensate for them by benefits to be yielded later on. The renailing of loose shingles is certainly not what the house is for; with respect to the house, it is a necessary evil; with respect to the hammer, however, it is a service rendered. Therefore the repairing of the house is at once a benefit and a COSt. Such double-faced events are so important as to require a special name. We shall call them interactions. Each inter action takes place between two instruments or groups of instruments. An interaction, then, is a double-faced event, at once a bene fit or service of the acting instrument, and a cost or disserv ice of the instrument acted on. There can never arise the slightest doubt as to when it is to be regarded as positive and when negative. The definitions of benefit and cost settle this question in each case. If it is desired by the owner of a given instrument that this instrument should occasion a given event, then the event is “desirable” or a benefit. If it is desired that an instrument should not occasion a given event, then the event is “undesirable” or a cost. Thus, since the house owner desires that the house should not occasion repairs, these repairs are costs of the house; * In this instance and throughout the following discussion we shall consider capital in its broader sense as including free human beings. Sec. 2) COMBINING INCOME ACCOUNTS 77 and since he desires that the tools should produce repairs, such repairs are the benefits from those tools. The example given is typical of the general relations be tween interacting instruments. The mental picture we should construct is that of two distinct groups of capital. Group A acts on, and, so to speak, benefits Group B. What ever the nature of this interaction, A, the giver of the bene fit, is credited with it and B, the recipient, is debited with it as a cost. These two items of credit and debit are equal and simultaneous because they are the selfsame event looked at from opposite sides. Interactions constitute the great majority of the elements which enter into income and outgo accounts. The only benefits which do not form merely the positive side of such canceling interactions, and so do not cancel out, are satis factions — desirable conscious experiences – often called “consumption ” (these are credited to the things enjoyed — for instance, a house); and the only costs which do not form merely the negative side of such canceling inter actions, and so do not cancel out, are “labor and trouble ’’ (these are debited to human beings). But these two final elements – “satisfactions,” on the one hand, and “labor and trouble,” on the other — are only the outer edges of the series of interactions. Between them lies a connective chain of productive processes and commercial transactions, every link of which has two sides, a positive side of benefits or services and a negative side of costs, always mutually canceling. § 2. Production: Interactions which Change the Form of Wealth The interactions between two articles or groups of articles are of three chief kinds: changes in the form of wealth, changes in the position of wealth, and changes in the owner ship of wealth; in other words, transformation, transporta 78 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. V tion, and transfer or exchange. All three may be called “production,” although this term is sometimes confined to the first two and sometimes even to the first alone. These we shall take up in order, and show how each is a two faced event or an interaction. First, what is here called “transformation ” of wealth is practically identical with what is usually understood by “production ” or “productive processes.” By this trans formation or change in the form of wealth is meant the change of relative position of its parts. Weaving, for instance, is the transformation of yarn into cloth by a re arrangement in the relative positions of the warp and woof. Spinning, likewise, consists in moving, stretching, and twist ing fibers into yarn; sewing, in changing the position of thread so that it may hold cloth together; and so it is with carding, wool sorting, shearing, and all the other operations which constitute the manufacture of fabrics. All these operations—which include all manufacture and all agriculture — consist simply of a series of transformations of wealth, each transformation being a two-faced operation. With respect to the transformed instrument or instruments, the transformation is a cost; with respect to the transform ing instrument or instruments it is a benefit. So it is when a loom produces cloth out of yarn, or when land renders a service in producing wheat. So it is, not only when a carpenter and his tools build or repair a house, but also when the painter decorates it or the janitor cleans it; or when a cobbler transforms leather into shoes, or when a bootblack transforms dirty shoes into clean and polished ones. The principle is not altered when the interaction consists, not in producing a change, but in preventing one. A ware house renders its service as a means of storing bales of cotton, i.e., protecting them from the elements; and this storage is, on the part of the stock of cotton, an element of outgo, or ex pense, as on the part of the warehouse it is an item of income. Sec. 2) COMBINING INCOME ACCOUNTS 79 Nor is the principle altered when there are, as indeed is usually the case, more articles than one in either or both of the two interacting capitals. Plowing, or the transformation of land into a furrowed form, is performed by a plow, a horse, and a man. The plowing is a cost debited to the land, on the one hand, and at the same time a service credited to the group consisting of the plow, horse, and man, on the other. Nor is the principle altered if one or more of the trans forming agents perish in the transformation and another comes for the first time into existence. Bread making is a transformation debited to the bread and credited to the cook, the range, the flour, and the fuel, of which the last two are con sumed as soon as they perform their services. Agents which disappear in the transformation, but reappear in whole or in part in the product (as here the flour), are called “raw materials.” The production of cloth from yarn is a trans formation effected by means not only of the loom, but also of a number of other agents, among them the yarn itself, which thus vanishes as yarn and reappears as cloth. The cost of weaving includes the consumption of raw material — yarn; and this consumption of yarn is, on the part of the yarn itself, not cost, but service. It is the use for which the yarn existed. When cloth is turned into clothes, this transformation is a service to be credited to the cloth, and a cost to be debited to the clothes. All raw materials yield benefits as they are converted into finished products. Their conversion is, however, on the part of these prod ucts, always outgo and not income. In general, production consists of a succession of stages, and at each stage there is an interaction. The finished product of one stage passes over as the raw material of the next, and its passage from the earlier to the later stage is an interaction between the capitals of the two. Each opera tion is credited to the group of instruments earlier in the series and debited to the group next later in the Series. 8o ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. W. §3. Transportation: Interactions which Change the Posi tion of Wealth The second class of interactions we have called “trans portation.” It is a very slight distinction which separates this class from the preceding class. Transforming or pro ducing wealth consists in changing the position of its parts as related to one another; transporting wealth consists mechanically in changing the position of that wealth as a whole. But “part ’’ and “whole ’ are themselves loose and relative terms. Bookbinding is a transformation or pro duction of wealth; it assembles the paper, leather, thread, and paste into a whole book. Delivering the finished book to a library is transportation. Yet the library is, in a sense, a whole; and to assemble books into a classified and organized library is to make a whole out of parts and may be regarded as a transformation or production of wealth. The distinction between transformation and transportation is thus merely one of convenience. Many writers prefer to include them both under “production.” We prefer to include them under the less ambiguous and more inclusive head of “inter actions,” and our object here is not to emphasize their difference but their similarity. The principles already discussed of coupling and canceling equal and opposite items apply also to transportation. The following are examples. When merchandise is transmitted from one warehouse to another, the stock in the first warehouse is credited with the change and that in the second, debited. The stock which has rendered up the merchandise has done a service; that which has received it is charged with a cost. A banker who takes money from his vault and puts it into his till will, if he keeps separate accounts for the two, credit the vault and debit the till. When wheat is carried from wheatfield to barn the wheatfield is credited and the barn debited. When wheat is imported from Canada, Canada is credited, and the United States debited. SEc. 4) 81 COMBINING INCOME ACCOUNTS § 4. Exchange: Interactions which Change the Ownership of Wealth The third class of interactions is the change of ownership of wealth or of property. This has been called “transfer.” Every transfer is a species of interaction. If two dollars are transferred from Smith's cash drawer to Jones's, Smith's cash drawer is credited with the two dollars yielded up, and Jones's is debited with receipt of the same. Transfers usually occur in pairs, and involve two objects transferred in oppo site directions between two owners. One transfer pertains to each object. Such a double transfer we have called an exchange. Since an exchange consists of two transfers, and since a transfer is a species of interaction and as such is self canceling, every exchange is self-canceling, and hence cannot be counted as a part of the total income of society unless it be counted out again (although it may lead to later items which are not self-canceling). Whatever is credited on one side is debited on the other. This is shown in the following scheme which gives the credits and debits involved when goods worth $2 are sold. The dealer credits his stock of goods and debits his “cash,” while the buyer does the Stocks of Goods | Stocks of CASH Seller's . . . . . . . Buyer's. . . . . . . Cr. $2 Dr. $2 Dr. $2 Cr. $2 opposite. We see, then, that an exchange, whether of goods against goods or of goods against money, occasions an element of income to the seller equal to the corre sponding element of outgo to the purchaser, and an element of outgo to the seller equal to the corresponding element of income to the purchaser, and therefore no immediate in come at all to Society. G 82 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. W. The effect of canceling these items — the credit item of the seller and the debit item of the purchaser — is to free the income account for any article from all entanglements with exchange, to wipe out all money-income, and to leave exposed to view the direct or natural income from that article. Thus books yield their natural income, not when the book dealer sells them, but later when the reader peruses them. The sale is a mere preparatory service, a credit item to the book dealer, and a debit item to the buyer. Only the book remains in the hands of the pur chaser. Again, a forest of trees yields no natural income until the trees are felled and pass into the next stage of logs. The owner of the forest may, to be sure, “realize " on the forest long before it is ready to be cut, by simply selling it to another. To the seller the forest has then yielded income; but, as the purchaser has suffered an equal outgo, the net result of this interaction, as of every other, is zero. Only the forest remains ready for future use. Similarly, the money “rent" of a rented house is, for society, not income at all. It is income to the landlord, but outgo to the tenant – outgo which he is willing to suffer solely because of the shelter he receives. As we may cancel the landlord's money-income against the tenant's money-outgo, it is clear that the shelter alone remains as the income from the house. The shelter-income is the essential and abiding item, and without it there could be no rent-income to the andlord. Thus we see clearly the fallacy of the old view that a dwelling yields income only when it is rented. In like manner, a railway yields as its natural income solely the transporting of goods and passengers. Its owners sell this transportation service for money, and regard the rail way simply as a money-maker; but to the shippers and pas sengers this same money is an expense, and exactly offsets the railway's money earnings. Of the three items — money-income of the road, money-outgo of its patrons, and transportation—the first two mutually cancel and leave only SEC. 4] COMBINING INCOME ACCOUNTS 83 the third, transportation, as the real contribution of the railway to the sum total of income. We do not mean, of course, that interactions are useless, but simply that in the accounting of Society they are self canceling. They are a necessary step toward achieving the final income which remains uncanceled, but they themselves ** disappear under the method of couples. We see that &*capital is not a money-making machine, but that its income to Sºciety is simply its services of production, transporta tion, and gratification. The income from the farm is the yielding of its crops; from the mine, the giving up of its ore; from the factory, its transformation of raw into finished products; from commercial capital, the passage of goods between producer and consumer; from articles in con sumers’ hands, their enjoyment or so-called “consumption.” Although these items are all measured in terms of money, they do not consist of money receipts. Those items which do consist of money receipts are money receipts for in dividuals, never for the world as a whole; since each dollar received by one person implies that some other person — the one from whom it was received — expended it. Similar principles apply to outgo, no part of which, for society, occurs in money form. The great bulk of what merchants call “cost of production,” expense, or outgo, consists of money costs which, as concerns society, carry with them their own cancellation, and so are not ultimate costs at all. For manufacturers, merchants, and other business men, almost every outgo is an expense, i.e., consists of a money payment. But such money payments are for wages, raw materials, rent, and interest charges, all of which are incomes for other people. The wages are the earnings of labor; the payment for raw material is received by some other manufacturer, farmer, or miner; the rent is received by the landlord; the interest charges, by the creditor. Labor itself — human effort, not the payment for it—re mains, however, uncanceled. 84 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. V § 5. Accounts Illustrative of Interactions in Production Not only do money transactions completely cancel them selves out in reckoning the total income of society, but the great majority even of the natural benefits of capital do the same. Even these natural benefits of capital consist for the most part of “interactions”; they are transformations or transportations of wealth. They are intermediate stages, merely preparatory to the final enjoyable benefits of wealth, and, after the interactions have been canceled out, do not enter as items either on the income or the outgo side of the social balance sheet. In order to show the effect of cancel ing out the equal and opposite items entering into every interaction throughout all productive processes, let us ob serve the various stages of production which begin with the forest above referred to. The gross income produced by the forest is the series of events called the turning out of logs. This log production is a mere preparatory service, a credit item to the forest and a debit item to the stock of logs of the sawmill, to which the logs next pass. Next the sawmill turns its logs into lumber, and is therefore cred ited with its share in this transformation while the lumber yard is debited with the production of lumber. Intermedi ate categories may, of course, be created, and we may follow, in like manner, the further transformation, transpor tation, and exchange to the end of the stages of produc tion — or rather, to the ends; for these stages split up and form several streams flowing in different directions. To fol low one only of these streams, let us suppose that the lumber which goes out from the yard is used in repairing a certain warehouse. The warehouse is used for storing cloth; the cloth goes from the warehouse to the tailor; the tailor con verts the cloth into suits for his customers; and his cus tomers receive and wear those suits. In this series of productive services, all the intermediate services cancel out in “couples’’ and leave as the only uncanceled ele SEc. 5) 85 COMBINING INCOME ACCOUNTS ment, or fringe of final services, the use of clothes in the consumers' possession. Should we stop our accounts, however, at earlier points in the series, the uncanceled fringe at which we should find ourselves would be some other item. The uncanceled in come item in a production series is always the positive side of some intermediate service or interaction whose negative side does not appear, as it belongs to a later stage in the series. This will be clear if we put the matter in figures, stage by stage. The following are the items for the logging camp above mentioned, in the accounts of its owner. INCOME ACCOUNT FOR LOGGING CAMP INCOME Yielding of logs to sawmill OUTGO . $50,000 The income from the logging camp is here seen to consist in the production of $50,000 worth of logs. Of course there are usually large outgoes; but as these do not con cern our present point, for simplicity we leave them out of account. If we now combine the account of the logging camp with that of the sawmill, we shall have accounts like the following, in which, to avoid irrelevant complica tions, no mention is made of any outgoes which do not happen to be interactions between the groups of capital considered:— INCOME ACCOUNT FOR LOGGING CAMP AND SAW MILL CAPITAL SOURCE Logging camp . . INCOME OUTGO . . Yielding logs to saw mill . . . $50,000 Sawmill . . . . . . Yielding lumber to lumber yard $60,000 Receiving logs from camp . . $50,000 g 9o,ooo Receiving . stock 500,ooo stock tailor's from suits 8Warehouse. . cloth to shelter |Warehouse 70,000 yard from lumber 0,000 Receiving warehouse from cloth Receiving - |YSawmill 60,000 yard to lumber $50,000 camp logging from logs . ielding Receiving 6YLumber . sawmill from Receiving 7o,ooo warehouse to lumber yard ielding 0,000 SNPECIFIED A ACCOUNT IINCOME OF SERIES 1910 FOR STRUMENTS OUTGO INCOME SOURCE CAPITAL Yielding in of 9Stock tailor. to Scloth 8| . warehouse from helter o,ooo 0,000 l 6oo,ooo . “wear” Yielding 5oo,000 . customers to suits Yielding $Logging . sawmill to logs Yielding camp. 50,000 customers clothes of Stock tailor. cloth of Stock SEc. 5] COMBINING INCOME ACCOUNTS 87 In this case, canceling the two log items of $50,000 each, we have left only the lumber item; that is, the net income from the combined logging camp and sawmill consists only of the production of lumber, their final product. The transfer of logs from one department to the other no longer appears. This transfer is like the taking of money from one pocket and putting it into another – a fact which would be particularly evident in case the logging camp and sawmill were combined under the same management. Extending the same principles to the entire series, we have the accounts as given in the table on the preceding page. In this table we may successively cancel each pair of items constituting an interaction. An item on the left is the positive side of an interaction of which the item on the right in the line next below is the negative side. Thus, as previously, the $50,000 in the first line on the left cancels the $50,000 in the second line on the right. Similarly, the two items of $60,000 cancel in the two lines next below, to the right and left, respectively. If we stop after the first two cancellations, thus restricting the account to the first three horizontal lines of the table, we shall find that the net in come from logging camp, sawmill, and lumber yard consists only of the production of retail lumber, worth $70,000; it includes neither the transfer of logs from the camp to the mill nor the transfer of lumber from the mill to the yard. In like manner, if we proceed one stage further, i.e., if we stop our cancellations at the end of the first three interactions, the production of retail lumber no longer appears as an ele ment of income; and so on, step by step to the end, when the only surviving item will be the “wear ” of the suits. It is, of course, true that in any actual accounts there will be other items besides those which have been exhibited in this simple, chainlike fashion. Were it worth while, we might insert these additional entries of income and outgo elements. Most of them would likewise consist of the posi tive or the negative side of interactions; and if we were to 88 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. V introduce their respective mates, the opposite aspects of the same interactions, it would be necessary to include the accounts of still other instruments. If we should follow up all such leads, we should soon have, instead of the simple chain represented in the table, an intricate network of re lated accounts; but the same principle of the interaction as a self-effacing element would continue to apply. § 6. Preliminary Results of Combining these Income Accounts The table given will throw light on the question: Of what does income consist? or, to be more definite: Of what does the income from a particular group of capital goods consist? Whether the yielding of logs by the logging camp to the sawmill is income or not depends upon what capital we are including. It is income with respect to the first link of capital in our series (the logging camp); it is not income with respect to the first two links (the logging camp and the sawmill taken together), but merely a self canceling interaction between the two. Likewise the use of the warehouse is income with respect to the first four links of capital, but is not income with respect to the first five links. We see, therefore, that in reckoning up the income from any group of capital we may as well omit all interactions taking place within it, and confine ourselves to the outer fringe of services performed by the group as a whole. As the group is enlarged, this particular outer fringe disappears by being joined to the next part of the economic fabric, and another fringe still more remote appears. To answer the question whether any particular item is or is not income— as, for instance, the question, “Is sawing lumber income P” — we must first ask, “Income from what?” Income is always relative to its source. Contrasting the method of couples with the method of SEC. 6 89 COMBINING INCOME ACCOUNTS balances, we may say that the method of couples is useful in showing of what elements income consists in any given case. The method of balances, on the other hand, is useful in exhibiting the amount of income contributed from each capital source. The two methods, as applied to the example just given, are as follows: — (Summarized from Table on p. 86) METHOD OF BALANCES CAPITAL INCOME Logging camp . . Sawmill . . . . Lumber yard . . . . . . . . . $ 50,000 . 60,000 . 7o,ooo Warehouse . . . . OUTGO NET INCOME $ 50,000 $ 50,000 Io, Ooo 60,000 Io, Ooo 8o,ooo 7o,ooo Io,000 Stock of cloth in warehouse 90,000 Stock of cloth of tailor . . 5oo,ooo Stock of clothes of customers 6oo,ooo 8o,ooo Io,000 90,000 4Io,ooo . . 5oo,ooo Ioo,ooo $600,ooo METHOD OF COUPLES INCOME OUTGO The two methods — balances and couples — show the same final result ($600,000), but from different points of view. By means of the method of balances we are enabled 90 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. V. to see that, of this $600,ooo, the part contributed by the logging camp is $50,000, that contributed by the sawmill, $10,000, and so on. By means of the method of couples, we are enabled to see that, canceling by the oblique lines, we have left but one item, $600,ooo, representing the “wear” of the suits. Thus the entire $600,ooo consists of the use or “wear” of the suits, although five-sixths of it is contributed by other kinds of capital than the stock of clothes of customers. Combining the results of both meth ods, we may state that the total net income from the speci fied group of instruments consists of $600,000 worth of “wear” of suits, and that this is due partly to the stock of clothes and partly to other capital. Of course our table does not give all the capital to which the wear of the suits is indebted. We have, as already noted, omitted, for the sake of simplicity, all items of cost which do not belong to our chosen series. But the inclusion of other items, while it complicates the accounts, does not change the principle of cancellation. It merely introduces other chains of interactions. § 7. Analogies with Capital Accounting The two methods correspond in a general way to the two methods for canceling liabilities and assets in capital ac counts. Applied to capital, the method of balances gave, it will be remembered, the amount of capital belonging to each individual; the method of couples showed of what elements the total capital consists. Similarly, applied to income, the method of balances shows what share of the resulting income is contributed by any articles or groups of articles of capital; while the method of couples shows wherein that resulting income consists. Let us consider for a moment the method of couples as applied to the two sorts of accounts. In capital accounts the self-effacing items were debts; in income accounts the self-effacing items were interactions. These concepts — Sec. 7] COMBINING INCOME ACCOUNTS 9I debts and interactions — supply the key for the mutual cancellations between accounts. A debt is both positive and negative and so is self-canceling. An interaction is likewise both positive and negative and so self-canceling. A realization of the two-faced nature of debts helps us to avoid the confusions of double counting in capital accounts and double taxation; a realization of the two-faced nature of interactions saves the confusions of double counting in income accounts. It is important here to observe of income, as was pre viously observed of capital (Chapter III, § 8), that the self effacement of the self-effacing elements (interactions in the case of income) does not mean that the total income would be just the same if there were no interactions. On the contrary, the existence of interactions—the operations of industry and commerce – are essential steps toward the final goal of uncanceled income to which they lead. Without them the final uncanceled income would be very much less and often nonexistent. Debts mean subdivided ownership of capital and interactions mean subdivided steps in income. They make capital and income respec tively more abundant and effective. We may illustrate what has been said by two simple examples. If a man owns a piece of real estate worth $1oooo and mortgages it for $6000, this debt must be entered in his accounts as a liability of $6000 and in the accounts of the mortgagee as an asset of $6000. Conse quently, as between the two men the item cancels out. But this does not mean that the mortgage is of no ac count. It does not mean that the two men would be just as well off if there were no mortgage. If we should force them against their will to cancel the debt, it would be an inconvenience to both. The owner would find it difficult to make the payment and the mortgagee would have the inconvenience of finding another investment for the $6000 returned to him. The inconvenience to the owner might 92 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. V be so great that he would be forced to sell his land per haps at a sacrifice below the $10,000 which is its real worth, while if the mortgage is allowed to stand, he might not be willing to sell even for a sum considerably above the $10,000. The inconvenience to the mortgagee might be less. We find the same thing true of interactions. A book seller who sells $2000 worth of books in the course of a year credits his business with this sum while his customers debit their libraries with $2000 worth of books. These entries are evidently correct accounting, and the receipts of the bookseller and the expenditures of his customers exactly offset each other. But this does not mean that the transactions are of no account. Without them the bookseller would find a great accumulation of books which would be entirely useless to him while his customers would be deprived of the satisfaction of reading these books. If we could force the reversal of the normal process and make the customers resell their books to the dealer, there would be an obvious loss to both parties. The dealer would refuse to take them except at a price far below the $2000, while their possessors would not be willing to sell them unless for more than $2000. §8. Double Entry in Accounts of Fictitious Persons We have now followed the cancellations to which inter actions lead, whether they be interactions of exchange or of production. The case of exchange, however, needs further consideration. Since every exchange consists of two trans fers, and every transfer of two items, a credit and a debit, the exchange evidently consists of four items in all, two of which are credits and two of which are debits. These four may be paired off in two ways, only one of which has thus far been mentioned. They stand, as it were, at the four corners of a square, as in~ the scheme given in § 4. --~ -- SEc. 8] COMBINING INCOME ACCOUNTS 93 The two transfers into which any exchange may be re solved are represented by the second and third columns of that scheme. The second column indicates that a $2 article has been transferred from the stock of the seller to that of the buyer, being, therefore, credited to the one and debited to the other; the third column indicates that $2 of money has been transferred from the stock of cash of the buyer to that of the seller and credited and debited accordingly. But this same exchange may also be resolved into two pairs of items represented by the two horizontal lines of the scheme. The upper line indicates that the seller has exchanged goods for cash crediting his goods with the sale and debiting his cash; the lower line indi cates the reverse conditions for the buyer. Every exchange, then, consists of four items, and may be resolved either into two transfers (one for each good ex changed) or into two transactions (one for each person exchanging those goods). These latter items, namely, transactions represented by the horizontal lines, we must now consider more fully. Each of the previous income accounts is an account of in come flowing from a specified good owned, not of the entire income received by a given person as owner. But it is easy now to form the income accounts of any given person, i.e., the income and outgo of all his assets and liabilities, simply by combining in each case, by the method of balances, the accounts of all his items of property (whether assets or lia bilities). We must distinguish, however, the accounts of real and of fictitious persons. We begin with the income account of a fictitious person. The following account represents the entries during a given year for a dry goods company. In this account we observe that every item on the income side is balanced by an equal and opposite item on the outgo side. All items thus paid are represented by the same letters, the capitals being used for positive items and the small letters for negative. 94 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. V. INCOME AND OUTGO OF A DRY GOODS COMPANY FOR CAPITAL SOURCE INCOME 1910 OUTGO Stock of goods | By goods sold $1o,ooo A. To goods bought $5,000 b Cash . . . . . By cash taken out To cash received for purchases $5,000 B | from sales . . $1o,ooo a for profits $2,000 C Capital Stock . (a liability) To dividends $2,000 c The rule we have learned in Chapter IV for making com plete income accounts is to start with the capital account, taking each item of assets and each item of liabilities, and to enter for each item of either kind all the items of income to which they give rise, plus or minus, as the case may be. For simplicity, it is here assumed that, instead of fifty or one hundred different items of capital, there are only three items; namely, the stock of goods, the stock of cash, and the “capi tal stock,” which is “negative capital.” The stock of goods yields $10,000 worth of sales. But, on the other hand, it costs $5000 to replenish this stock of goods. Therefore it is credited with a plus item of $10,000, and debited with a minus item of $5000. The student will notice, moreover, that each of these items is entered twice, once on each side. The doubly entered items may be mutually canceled. A cancels with a ; that is, though the stock of goods is credited with bringing in $10,000 (A) in cash, the cash drawer must be debited with the $10,000 (a) which it swallows up. Like wise the stock of goods costs $5000 (b), which must therefore be debited to it; but the cash drawer has to supply this $5000, and is therefore credited with $5000 (B), so that items B and b cancel. Finally, when the profits are paid, they also come out of the cash drawer, and the cash drawer is SEc. 9] COMBINING INCOME ACCOUNTS 95 credited with exactly that amount, $2000 (C); while the “capital stock” is debited with that amount as a cost (c). So we see that all six items cancel one another in pairs. The two sides of the account of such a fictitious person necessarily balance. Even if the company accumulates its profit instead of paying it in dividends to the shareholders, the two sides of its account still balance; for, as has been seen, all money received is not only credited to the capital source which brought it in, but is also debited to the cash account. Here, for instance, the $2000 item (doubly entered as C and c) would merely be omitted. There would be no $2000 dividends, but the cash drawer would be $2000 fuller. $9. Double Entry in Accounts of Real Persons In the case of real persons, however, the two sides do not balance, for the accounts do not then consist solely of double entries. To show this, let us consider the accounts of a real person as given in the next table. In these accounts, as in the previous ones, both of which are much simplified, we have indicated the like items on opposite sides by like letters, the positive items being represented by capitals and the negative by small letters. We observe that, as in the accounts of the previous company, many of the items will “pair.” But, unlike the company's accounts, the present accounts contain a residue of items which will not pair. The letters representing these unpaired items are designated on the next page by being inclosed in square brackets. They show that [B] and [C] – the shelter of the house, and the use of food — constitute a kind of income which does not appear elsewhere as outgo. When studying the accounts of goods owned, we found in considering the chain of productive services of a lumber camp, etc., that there always remains some outer fringe of uncanceled income. We have now reached this same kind 96 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. V INCOME AND OUTGO OF A REAL PERSON FOR THE YEAR 1910 CAPITAL SOURCE INCOME OUTGO Stocks and bonds. By receipt of money from To money expended stocks and bonds $200o A for stocks and bonds . $500 d - Lease right . . . By shelter . Food . . . By use of food . . . . . $10o [B]|To money rent paid . . $10o e . $150 [C]|To money cost of food . . $150 f “Cash” . . . . By cash taken out for To receipt of money stocks and bonds $500 D | from stocks and bonds . $2000 a By payment for rent $100 E |To receipt of money for work done . $20oog By payment for food $150 F Self . . . . . By receipt of money for work done . . . . $ 2000 G Uncanceled items: Shelter [B] . . $10o Use of food [C] . $150 Total uncanceled income . . . . $250 of outer fringe in studying the accounts of owners, provided they are real persons. This outer fringe consists of the final benefits of their goods. All other items are merely interactions preparatory to such final benefits, and pass from one category of capital to another. Thus the in come from investments, being paid into the cash drawer, is outgo with respect to the drawer; the drawer yields income by paying for stocks and bonds, food, etc., but in each case the same item enters as outgo with respect to these or other Sec. 9] COMBINING INCOME ACCOUNTS 97 categories of capital. In all these cases the individual re ceives no income which is not at the same time outgo. It is only as he receives shelter from the house, consumes food, wears clothes, or uses furniture, or some other article, that he receives income. And these final benefits are, of course, the end and goal of all the preceding economic processes and activities. We have thus reached what may be called the stage of final or enjoyable income. This is the stage at which wealth at last acts upon the person of the recipient. This final income is that of which the economist is in search, and is that which the ordinary statistics of workingmen's expen ditures represent. It has been made clear that, in the final net income which we derive from wealth, all interactions between different articles of wealth drop out—all the trans formations of production, such as the operations of mining, agriculture, and industry, all the operations of transportation, and all transfers and exchanges in business. For in all such cases the debits and credits inevitably occur in pairs of equal and opposite items. Each pair consists of the opposite facets of the same interaction. The only items which survive are the final personal uses of wealth. The chief classes of such uses or benefits are those of nourishment, shelter, and clothing. Having reached the action of wealth on the human body, we may, as students of economics, be content to stop. But, theoretically, there is one step more before the process of tracing a series of interactions has reached its final goal. Indeed, no benefits outside ourselves are of significance to us except as they lead to feelings within our minds. And if we regard the human body in the same light in which we have regarded articles of wealth, we could extend our accounts bby conceiving wealth as interacting with the human body. We would then debit the human body with the nourishment, shelter, pro tection from cold, etc., which it receives from food, dwellings, H 98 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. W. clothing, etc., and credit it with the satisfactions experienced through the brain, i.e., the feelings of enjoyment of food or avoidance of pain, etc. As, however, we have in general, in this textbook, limited the concept of wealth to its nar rower definition, excluding free human beings, we shall not attempt to follow these transformations of income after they reach the person of the owner. Usually the mental satisfactions follow so closely after the physical effects of wealth on the human body that practically we scarcely need to distinguish between those physical effects and the resulting satisfactions. Hereafter we shall speak of satis factions of food, shelter, clothing, etc., as if they flowed directly from these external objects. § Io. Ultimate Costs and Income We have now reached a convenient place at which to emphasize a point of great importance, but one which is seldom understood; namely, that most of what is called “cost of production ” is, in the last analysis, not cost at all. We have found, in using the method of couples, that every item of money cost is also an item of income, and that in the final total no such items survive cancellation. It costs the baker flour to produce bread; but the cost of flour to the baker is a benefit to the miller. To society as a whole, on the other hand, it is neither cost nor benefit, but a mere interaction. As has been said, in the last analysis, payments of wages, interest, rent, or any other payments from one mem ber of Society to another, are not costs to society as a whole. This fact should now be clear; yet it is commonly over looked. When people talk of the cost of producing coal or wheat, they usually think of money payments. The items called costs of production are mostly payments from per son to person, or interactions, at various stages of produc tion. We have seen that each such item is two-faced and, Sec. Iol COMBINING INCOME ACCOUNTS 99 in the final total, wipes itself off the slate. The only ulti mate item of cost is labor cost or efforts; that is, all the experiences of an undesirable nature which are undergon in order that experiences of a desirable nature may be secured. We may conclude, therefore, that in the last analysis income consists of satisfactions and outgo of efforts to secure satisfactions. Between efforts and satisfactions may intervene innumerable interactions, but they all must cancel out in the end. They are merely the machinery connecting the efforts and satisfactions. At bottom, eco nomics treats simply of efforts and satisfactions. This is evident in the case of an isolated individual like Robinson Crusoe, who handles no money; but it is equally true of the most highly organized society, though obscured by the fact that each member of such a society talks and thinks in terms of money. In the light of the foregoing principles we are now in a position to take a bird's-eye view of the income of any coun try. Unfortunately, there are no available statistics for income in the United States. We can only guess as to what the amount of it may be. Possibly $20,000,000,000 worth of final income is annually enjoyed in the United States, of which about one third is in the form of nourishment or food uses, about one sixth in the form of shelter, and about one eighth in the form of clothing. These and the other items of the direct uses of wealth constitute the real income of society. In other words, our real income is what is often called our “living.” Money-income, as we have seen, is not real income, but is converted or spent for real income in what we call our “bread and butter,” which, more exactly expressed, means the use of our “bread and butter” and of the other goods contributing direct benefits to human beings. These uses include the necessaries, comforts, luxuries, and amusements of life. These are what make up our “living.” The more money wages it costs to acquire a given amount of real wages, IOO ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP.W the higher the “cost of living” of which we hear so much to-day. The money which the workman is paid in wages is not his real wages, but only his nominal wages. The real wages are the workman's living for which that money is spent. Money payments, as we have seen, cancel themselves out when we take a view of the whole, for they are not only receipts, but also payments. They there fore disappear, just as in our view of capital the bonds and stocks disappear, being not only assets, but also liabili ties. And in exactly the same way the operations of pro duction and transportation cancel themselves out in the total production of the farms. The ten billions of dollars' worth of farm products, for instance, which we are produc ing are not a part of the income of the country to be added to our consumption of food, etc., any more than they are a part of the costs of the country. To the farmer they represent income, but to those who buy of the farmer they represent outgo, while to the country as a whole they rep resent neither income nor outgo. By the method of couples they vanish, and in their stead we have the consumption of bread and the other finished products which originated with the farm; and should we, as is sometimes erroneously done, try to add together the value of these finished products and the value of the farm products, we should be guilty of double counting, as would be the case in capital accounting if we should add the value of mortgages to the value of real estate. The method of couples thus provides us with a view of real income, making clear what it consists of and what it does not consist of. If, however, we wish to know the extent to which various agencies have produced this income, we must look at the matter from the standpoint of the method of balances. From this standpoint, perhaps three quarters of the total income enjoyed in the country is produced by human beings, the workers of society, the remainder being produced by capital in its narrower sense. Of this capi —-T SEC. Iol coMBINING INCOME Accounts. : : - ; 15: ...” tal that which produces the greater part of our income is land, but some of our income must also be credited to railways, ships, factories, shops, dwellings, etc. It does not matter whether the capital is or is not itself the prod uct of other capital, of human beings, or of nature. There will usually be a net income to be credited opposite each kind of capital, as shown in the table of the Method of Balances in § 6. CHAPTER VI CAPITALIZING INCOME § 1. The Link between Capital and Income WE have now learned what capital and income are, and how each is measured. We have seen that the term “capi tal” is not to be confined to any particular part or kind of wealth, but that it applies to any or all wealth existing at a given instant of time, or to property rights in that wealth, or to the values of that wealth or of those property rights. We have seen that income is not restricted to money income, but that it consists of all kinds of benefits of wealth. We have seen that, like capital, income may be measured either by the mere quantity of the various benefits or by the value of those benefits. We have seen that in the addition both of capital-value and of income-value there are two methods available for canceling positive and negative items, called respectively the “method of balances" and the “method of couples.” By the method of balances the nega tive items in any individual account are deducted from the positive items in the same account, and the difference or “balance ’’ gives the net capital (or income, as the case may be) with which that account deals, whether this net capital (or income) pertains to a particular instrument or instruments, or to all the property of a particular owner. The method of couples, on the other hand, cancels items in pairs and is founded on the fact that, as to capital, every liability relation has a credit as well as a debit side— IO2 | SEc. 1] CAPITALIZING INCOME IO3 namely, as related to creditor and debtor respectively; and that, as to income, every interaction is at once a benefit and a cost — a benefit occasioned by that good (or person) by which the event originates; a cost occasioned by that good (or person) for which it originates. We observed that it is the method of couples alone which, if fully carried out, reveals wherein capital and income ultimately consist. This method, applied to capital, gradu ally obliterates all partial rights, such as stocks and bonds, and exposes to view the concrete capital-wealth of a com munity. The same method applied to income obliterates the “interactions” such as money payments between persons, and exposes to view an uncanceled outer fringe of benefits and costs. It leaves simply the final benefits of the wealth, poured, so to speak, into the human organism — the satisfactions and the efforts of human life. We have seen that capital and income are in many re pects correlative; that all capital yields income and that all income flows from capital including human beings. In spite of this close association between them, capital and income have thus far been considered separately. The question now arises: How can we calculate the value of capital from that of income or vice versa 2 The bridge or link between them is the rate of interest. The rate of interest is the ratio between income and capital, both the income and the capital being expressed in money value. Business men, therefore, sometimes call the rate of interest the “price of capital’’ or the “price of ready money.” Suppose, for instance, that a merchant wants a capital worth $10,000 and is willing to pay a bank $400 per year for it perpetually; then the price the merchant pays for the capital (or the ratio between the annual payment to the bank and the capital received from it) is $400 + $10,000 = {{m, or four per cent, and the rate of interest is, therefore, said to be four per cent. We may also define the rate of interest as the premium on goods in hand at one date in terms of goods of the same IO4 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI kind to be in hand one year later. Present and future goods seldom exchange at par. One hundred dollars, if in hand to-day, is worth more than if due one year hence. To-day's ready money will always buy the right to more than its full value of next year's money. If, then, $100 to-day will ex change for $104 to be received one year hence, the premium – or rate of interest — is four per cent. That is, the price of to-day's money in terms of next year's money is four per cent above par; for $104 + $100 exceeds $1oo + $1oo by 1$o, which is four per cent. We have, then, two definitions of the rate of interest, viz., “the price of capital in terms of income " and “the premium which present goods command over similar goods due one year hence.” But the two definitions are quite consistent, and either defi nition may be converted into the other. The rates of interest in the two senses are, in fact, normally equal. For instance, if a man borrows $100 to-day and agrees to pay it back in one year with interest at four per cent, we may conceive of him as selling for $100 a perpetual income of $4 a year – and at the same time agreeing to buy it back for $100 at the end of one year. But these two stipulations — to sell and to buy back — amount simply to an exchange of $100 to-day for $104 next year – i.e., an exchange of present for future money at four per cent. Thus the rate of interest in the price sense becomes equivalent to the same rate in the premium sense. Or, beginning at the other end, conversely if we suppose $100 to-day to be exchanged for $104 due one year hence, so that the rate of interest in the premium sense is four per cent, we may suppose that when the time comes to receive the $104, only $4 of it is really kept, the $1oo being again exchanged for $104 due the year follow ing. If this process is repeated indefinitely, the man will continue to receive simply $4 a year; and thus the rate of interest in the premium sense becomes equivalent to the same rate in the price sense. Sec. 1] CAPITALIZING INCOME IOS By means of the rate of interest we can evidently translate, as it were, present money-value into its equivalent future money-value, or future money-value into its equivalent present money-value. To translate any present value into next year's value, when interest is four per cent, we multiply this year's value by the factor I.O4; to translate any next year's value into this year's value, we divide next year's value by the factor 1.04. Thus if the rate of interest is four per cent, $25 to-day is the equivalent of $25 × 1.04 due one year hence, i.e., $26. Or, vice versa, $26 due one year hence is worth in the present $26+ 1.04, or $25. Again, $1 due one year hence is worth in the present $1 + 1.04, or $o.962. In general we may obtain the present worth of any sum due one year hence by dividing that sum by one plus the rate of interest. This latter operation is what we learned in our school arithmetics as “discounting,” by which is meant finding the “present worth " of a given future sum. The rate of interest is thus a link between values at any two points of time – a link by means of which we may compare values at any different dates. The rate of interest, however defined, may be regarded as a species of price; but it is a very different species from any prices mentioned in previous chapters. We have seen that the price of wheat enables us to translate any given number of bushels of wheat into so many dollars' worth of wheat; and the prices of other goods in like manner, to translate their respective quantities into their money equivalents. Any price thus serves as a bridge or link between the quan tity of any good and its value in some other good, as money. By means of prices we can convert a miscellaneous assort ment of goods at any time into their money-value for that same time, or convert a miscellaneous assortment of benefits occurring through a period of time into their money-value for that same period. By such prices we may only convert quantities into simultaneous money-values. We cannot, by them, pass from one time to another. By means, however, Ioé ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI of that unique price called the rate of interest, we may convert the money-values found for one time into their equivalent at another time. The rate of interest is thus the hitherto missing link necessary to make our reckoning of money equivalents universal. We are not yet ready to explain how the rate of interest comes about. In fact, we are not yet ready to explain how any prices come about. We must, for the present, take the rate of interest ready-made, as it were, just as we have taken other prices ready-made. In the preceding chapters we have seen how to form capital accounts and income ac counts by assuming the prices necessary in each case to turn quantities into money-values. We are now ready, by as suming a rate of interest, to show the relations between these two sets of accounts – i.e., to turn income into capital. It is worth while, however, at the outset to rid our minds of the idea that money is the one and only source of interest, just as we have already rid our minds of the idea that money is the only kind of wealth. We may, as we have seen, express a great many things in terms of money-value which are not themselves money. This habit leads us unconsciously into the fallacy of thinking of these things as though they were actual money. If we question a man who says, “I have $10,000 of money invested, and from it I get $500 of money each year as interest,” implying a rate of interest of five per cent, he will be forced to admit that he has not really got $10,000 of money at all, and, perhaps, even that the $500 of money interest which he says he gets each year is not at first in money form. The true form of statement is simply that he has a farm (or other capital-wealth) which yields crops (or other products), and that both of these may be measured in terms of money, the farm being worth $10,000 and the crops $500. Money need not enter at all except as a matter of evaluating in bookkeeping. Hence, if we are careful, we shall avoid thinking and speaking of a fund of $10,000 producing an interest of $500, but will instead think SEc. 2] CAPITALIZING INCOME IoW and speak of actual capital, such as farms, factories, rail ways, or ships, worth $10,000 and producing actual benefits (such as yielding crops, manufacturing cloth, or transporting goods) which are worth $500. There is another confusion to be carefully avoided, viz., the confusion between interest and the rate of interest. If the interest from $10,000 worth of capital is $500 worth of benefits, the rate of interest is five per cent. Interest and the rate of interest are as distinct as value and price and in the same way. The rate of interest, then, is a sort of universal time price representing the terms on which men consider this year's values exchangeable in next year's or future years' values. By assuming this rate, we are enabled to convert future values into present, and present values into future. § 2. Capital as Discounted Income But although the rate of interest may be used either for computing from present to future values, or from future to present values, the latter process is far the more important of the two. Accountants, of course, are constantly comput ing in both directions, for they have both sets of problems to deal with ; but the problem of time valuation which nature sets us is that of translating the future into the present; that is, the problem of ascertaining the value of capital. The value of capital must be computed from the value of its expected future income. We cannot proceed in the opposite direction and derive the value of future income from the value of present capital. This statement may at first puzzle the student, for he may have thought of income as derived from capital, and, in a sense, this is true. Income is derived from capital-goods. But the value of the income is not derived from the value of those capital-goods. On the contrary, the value of the capital is derived from the value of the income. These re Io8 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI lations are shown in the following scheme in which the arrows represent the order of sequence – from capital wealth to its future benefits, from its benefits to their value; and from their value back to capital-value:— Capital-wealth –2- Flow of benefits (income) Capital-value -6- Income-value Not until we know how much income an item of capital will bring us can we set any valuation on that capital at all. It is true that the wheat crop depends on the land which yields it. But the value of the crop does not depend on the value of the land. On the contrary, the value of the land depends on the value of its crop. The present worth of anything is what men are willing to give for it. In order that each man may decide what he is willing to give, he must have: (1) some idea of the value of the future benefits his purchase will bring him, and (2) some idea of the rate of interest by which these future values may be translated into present values by discounting. With these data he may derive the value of any capital from the value of its income by means of the connecting link between them called the rate of interest. This deriva tion of capital-value from income-value is called “capi talizing” income or “discounting” income. § 3. The Discount Curve Let us assume that, for any given article of wealth or property, the expected income is foreknown with certainty, and that the rate of interest is also known. With these pro visos, it is very easy, by the use of the rate of interest, to compute the capital-value of said wealth or property; and this, whether the income accrues continuously or discon tinuously; whether it is uniform or fluctuating; whether the installments of it are few or infinite in number. Sec. 3] CAPITALIZING INCOME Io9 We begin by considering the simplest case; namely, that in which the future income consists of a single item becoming due at some particular time. If, for instance, one holds a property right by virtue of which he will receive at the end of one year a benefit worth $1.04, the present value of this right, if the rate of interest is four per cent, will be $1. Or if the future benefit one year hence is worth $1, its present value (interest being at four per cent) is found, as we have seen in § 1, by dividing the $1 by the factor 1.04. The result is $1 + 1.04, or $o.962. If the value to which the right entitles the owner is any other amount than $1, its present value is simply that given amount divided by 1.04. Thus the present value of $432 due in one year is $432 + 1.04, which is $415.38. Let us now take a period of two years instead of one. We know by “compound interest” (at 4 per cent) that not only will $1 amount to $1.04 next year, but that this $1.04 next year will amount to $1.04 × 1.04 or $1.082 the year after, - in short, that $1 to-day amounts in two years to $1 X (1.04)* or $1.082. Conversely, of course, the sum of $1.082 due two years hence is worth in present value $1.082 + (1.04)”, or $1. Similarly, the present value of, let us say, $10oo due two years hence is $10oo + (1.04)” or $924.21. We see then that, if interest is 4 per cent, we can, by multiplying by (1.04)*, translate any present sum into its equivalent two years hence, and we can, by dividing by (1.04)*, translate any sum due two years hence into its equivalent present value. By the same reasoning it is easy to show that we must multiply any sum in hand to-day by (1.04)” to obtain the equivalent sum due three years hence, and must divide any sum due three years hence by (1.04)” to obtain its present value. If the period is four years, we must multi ply or divide by (1.04)*; for five, by (1.04)", etc. For our present purposes we shall need to apply the process of divi sion by (1.04) or (1.04)” or (1.04)”, etc.; for our chief object is to translate future sums into present, not the reverse. ELEMENTARY PRINCIPLES OF ECONOMICS IIO [CHAP. VI We may illustrate this process by a diagram, much in the same way as geography is illustrated by a map. Curves sometimes puzzle beginners, but they are very important in economics, and render the subjects which they illustrate so clear and simple that the student should not fail to make himself master of their use at the outset. In Figure 3 the vertical distances measure the money and the horizontal distances measure the lapse of time. The sum of $100 (represented as b|3) is supposed to be due at the beginning of the year 1901. The problem is to find its value at the point of time represented by a ; that is, at the beginning of the year 1900, which we shall consider the “present instant ’’ or simply the “pres ent.” This discounted value is a A. If we draw the line BA, its slope downward from right to left pictures the fact that a future sum becomes smaller and smaller in present value the longer the period of time involved. # a This line BA is called the discount curve. - It is not a straight line, but a line such that its height at any point rep resents the discounted value of bH for the particular instant cor responding to that point. If the $100 due in 1901 be discounted in 1900 at four per cent, its value in the latter date will be $96.15, 4O 4O 4900 JSOI the difference in value between the two points of time being $3.85, as indicated in the dia gram, where a0 is equal to bb, and AC is the difference between ac or bp, the amount due in 1901, and a A, the discounted value of that amount in 1900. We shall understand the nature of this curve better if, instead of taking merely the interval of one year, we con sider a longer interval such as ten years. This is represented FIG. 3. SEC. 3] CAPITALIZING INCOME III in Figure 4. In this figure, as in the preceding figure, the vertical distances (or “latitudes”) above the base line represent sums of money and the horizontal distances (or “longitudes") represent periods of time. The curve, ABCDM is the discount curve. The latitudes of these points (or their vertical distances above the base line, abodm) represent the values of the same capital-good at different instants of time; and the longitudes or horizontal distances between them represent the intervals of time between those $ 1.50 J.I.O J oo 190o on 'oz 'os 'o'; 'os 'o6 oz 'o6 'os 'io FIG. 4. instants. Thus, let the point a represent the present instant, say the beginning of the year 1900, and let the longitude interval, ab, represent a year, say from the be ginning of 1900 to the beginning of 1901. Using equal intervals for successive years, we have a A representing any capital-value at the beginning of the year 1900, say $1, bb representing its equivalent next year, say $1.04, c0, the equivalent two years hence, and so on. We see that be is what we have called the “amount,” $1.04, of a A put out at interest for one year, and cc is the “amount” of the same II 2 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI compounded for two years. Conversely a A represents the present value in 1900, or discounted value, of any one lati tude on the curve, such as b13, as well as of any other, such as cC or d D. The latitude of any point on the curve may thus be regarded as the “amount" of the sum represented by any preceding latitude or as the “present value” of the sum represented by any succeeding latitude. Thus, if the total breadth of the diagram am represents ten years, we may either say that mM is the amount, at the end of the ten years, of the present sum a A, or that a A is the “present value" of the future sum, mM, discounted for ten years. The line AM not only ascends, but at an accelerating rate – i.e., it does not ascend in a straight line, but gradually bends upward, being continually steeper toward the right. The slope of the curve is due to the rate of interest, and the greater the interest in any given period of time, the more steeply will the curve slope. This curve, if prolonged to the left to show what the “present value" was prior to the time a, will, of course, never reach the bottom line. It keeps becoming flatter and flatter, so that its distance above the line can never become zero. If there were no rate of interest or if the rate of interest were zero, the curve would not slope at all, but would be a horizontal line. § 4. Application to Waluing Instruments and Property The principles which have been explained for obtaining the present value of a single future sum apply to many com mercial transactions, such as to the valuation of bank assets, which exist largely in the form of “discount paper,” or short time loans of other kinds. The value of such a note is al ways the discounted value of the future payment to which it entitles the holder. Similarly, the value of any article of wealth, reckoned when that wealth is in course of construc tion, is the present value of what it will bring when com Sec. 4) II3 CAPITALIZING INCOME pleted (less the present value of the cost of completion). For instance, the maker of an automobile will, at any of its stages in the course of construction, appraise it as worth the discounted value of the price expected for it when finished and sold, less the discounted value of the costs of construction and selling which still remain. Thus, if an automobile is to be sold for $5000 and requires a year before this sum will be realized, while it will cost to complete a sale $2000, which sum for simplicity, we also assume is payable at the end of the year, the present value of the automobile will be the present value of $5000 minus $2000, which, at four per cent, will be ($5000 – $2000) + 1.04, or $2884.62. The element of risk should not, of course, be overlooked; but its consideration does not belong here. Another application of these principles of capitalization is to goods in transit. A cargo leaving Sydney for Liverpool is worth the discounted value of what it will bring in Liver pool, less the discounted value of the cost of carrying it there. Another good example is a young forest, which is worth the discounted value of the lumber it will ultimately form. - Ordinarily, however, we have to deal, not with one future sum, but with a series of future sums. A man who buys a bond or a share of stock is really buying the right to a series of future items of income. But we can treat a series of items of income by discount curves in exactly the same way that we can treat one such item. For instance, let us consider a $10o “five per cent” ten year bond. Such a bond is simply a promise to pay $5 each year for ten years and at the end of these ten years to pay in addition the “principal’’ sum of $100. The problem is to discover the present value of the bond. This is evidently the discounted value of the eleven sums which the owner will receive from the bond; in other words, the discounted value of the “principal,” due ten years hence, together with the discounted values of the ten separate in I II4 ELEMENTARY PRINCIPLES OF ECONOMICS [CHAP. VI terest payments due respectively one year, two years, three years, etc., up to and including ten years from date. As we have just seen how to get the discounted value of any one of these sums, it is simply a question of arithmetic to calculate them all and then add them together. Before we can perform the calculations, however, we must know what rate of interest to use. The mere fact that the bond is called a “five per cent” bond does not mean that those who buy the bond will calculate its present value to them by discounting its benefits at five per cent. The five per cent named in the bond is called the nominal rate of in terest. It may or may not be the same as the rate of interest used by investors in ascertaining the present value of the bond. This latter rate is called the rate “realized.” If the rate realized happens to be the same as the nomi nal rate of interest, i.e., that named in bond, the present value of the bond will be par, or $100. This can be shown in various ways, as by calculating separately all the eleven different sums to which the bond entitles the owner; namely, the ten interest payments of $5 each and the final principal of $100. Such a calculation shows that the present value of the first interest payment of $5 (namely, that due one year hence) is $5 + 1.05, or $4.76; that the present value of the second interest payment of $5 is $5+ (1.05)”, or $4.55; that the present value of the third interest payment is $5 + (1.05)”, or $4.32; that the present value of the fourth interest payment is $5 + (1.05)*, or $4.11; and so on up to the tenth, the present value of which would be $5 + (1.05)" or $3.07. To this series must be added the present value of the principal, which, being discounted for ten years, is $100 + (1.05)", or $61.39. The sum of all these will be $4.76 + $4.55 + $4.32 + $4.11 + $3.92 + $3.73 + $3.55 + $3.38 + $3.22 + $3.07 -- $61.39 = $100, which is the present value of the bond. S > Another method of getting the same result is, beginning our calculation at the time when the bond falls due in the SEc. 4) CAPITALIZING INCOME II5 future, to proceed backwards, discounting year by year. It is evident that just before the payment of the bond it will be worth $105; for at that time there is immediately due $5 of interest and $100 of principal. Any time earlier in the ninth year, the value of the bond will evidently be the discounted value of this $100 and this $5, the discount being for whatever portion of the year may be involved. Just after the ninth interest payment, and just one year be fore the date when the $105 are due, the value of the bond will evidently be found by discounting $105 for one year at five per cent. This gives $105 + 1.05, or $100. In other words, the value of the bond at the end of nine years, just after the ninth interest payment, will be par, or $100. The instant preceding, namely, just before the ninth interest payment, the value of the bond will be more by the amount of interest payment, $5. That is, the value of the bond will be $105 just before the ninth interest payment and $10o just after. This sudden drop of $5 is due to the abstraction of the $5 of interest. For this reason, care is always taken by brokers at or near the time of interest payments to specify whether the bond is to be sold with the interest payment or without it, the higher price being paid if the bond is bought before the interest has been abstracted. Thus, the instant before the ninth payment of interest the bond is worth $105, just as was the case the instant before the tenth and last payment. By the same reasoning, there fore, its value one year earlier, just after the eighth interest payment, will be $100 and just before, $105. In this manner we may proceed year by year back to the present, finding that the value of the bond will be $100 just after any interest payment and $105 just before. Its value will therefore be $1oo just after the first interest payment, which occurs one year hence, and $105 just before that payment. The value of this $105 at the present instant will therefore be $100. Reviewing these figures in the reverse order, we see that the value of the bond begins at $100, ascends to $105 one ELEMENTARY PRINCIPLES OF ECONOMICS II6 (CHAP. VI year from date, then drops suddenly to $100, ascends during the next year to $105, and then drops, and so on, ascending and dropping, as it were, by a series of teeth until the whole ten years have elapsed, when the value reaches its last height of $105 and then disappears altogether. In these oscillations, the gradual rise of $5 each year is evidently the accrued, while the sudden fall of $5 at the end of each \interest year is the income taken out. It is appropriate, here, to remind the student, that the entire height from the base line to any point in this tooth too M 1 2 3 4 5 e 7 a A. A FIG. 5. like curve— whether at highest or lowest or anywhere between — represents the value of the capital at the cor responding instant of time. This should be constantly borne in mind. The life history of such a bond can best be seen by the aid SEc. 4) CAPITALIZING INCOME 117 of Figure 5. The ten small, dark lines marked “5” stand ing on the base line MA (or the equivalents of these above the par line) and the long, dark line A B represent the eleven sums to which the bondholder is entitled; in other words, the small, dark lines representing the interest payments in the ten successive years, and AB, the principal, $100, due at the end of the ten years. The problem is: Given these eleven sums to which the bondholder is entitled, to show in the diagram the value of the bond at different dates. Assuming as before that the rate of interest used in comput ing is 5 per cent, we obtain the results seen in Figure 5. We observe that the value of the bond, just before it be comes due, is the sum of Aa (or BC, $5 of interest), and A B (the $100 of principal). This sum is represented by the vertical line AC. One year earlier, just after the ninth interest payment A'a' (or B'C'), the value of the bond is A'B', or $100, being the discounted value of AC obtained by draw ing the discount curve CB'. The value just before the ninth interest payment will be A'C', or $105. Continuing in this manner backward, we obtain the series of “teeth,” as in dicated in the diagram. If the various discount curves in Figure 5 are all continued to the left (as in Fig. 6), they will divide the line MN, rep resenting the present value ($100) of the bond, into the eleven parts of which it is composed, each part representing the present value of one of the eleven payments to which the bond entitles the owner. Thus the present value of the principal is seen to be $61.39, this being the height above M at which the lowest discount curve meets MN; the present value of the last or tenth interest payment is $3.07, this being the difference in height between the two lowest discount curves; the present value of the ninth interest payment is $3.22, as indicated in the next space above. Similarly, the present value of each of the other future payments is indicated in the diagram. The parts into which MN is divided thus form a picture II8 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI of the eleven present values calculated earlier in this section. As we pass from left to right in the diagram, we see that the value of the bond at the beginning of each year is $1oo, made up of the discounted values of all the remain ing future receipts; and that the value increases each year along a discount curve to $105 at the end of the year, im M 1 2 3 4 5 e 7 6 A. A FIG. 6. mediately before the annual payment is made. The value then drops again to $100, when this annual income is received. It thus continues to oscillate (just as in Figure 5) between $100 and $105 each year to the end, when the final income of $105 is received. But often the bond is not sold at par because the rate of interest used by the purchaser in calculating what he is Sec. 4) CAPITALIZING INCOME II9 willing to pay for it may be more or less than the five per cent named in the bond; in other words, the rate realized by the purchaser may be more or less than the nominal rate. When a bond is sold above par, this fact shows that the rate of interest realized by the investor is less than five per cent. In this case the bond is only nom inally a “five per cent bond.” If the rate used in calcu lating the value of the bond is four per cent, that value IOB.17 Poir vite}oo FIG. 7. will be found to be $108.17; so that if the bond is sold at $108.17, the purchaser is said to “realize' four per cent. It will be seen that the rate realized is that market rate which is actually used for discounting eleven items, namely the ten annual items of $5 each and the final item of $100. I2O ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI The value of the bond, $108.17, is found in the way already explained and is illustrated by the discount curves in Fig ure 7. Expressed arithmetically the calculation consists in adding together the following: the present value of the first payment of $5 (namely that due one year hence) which is $5 + 1.04, or $4.81, then that of the second which is $5 + (1.04)” and so on up to and including the present value of the principal which is $100 + (1.04)". The sum is $108.17. Here the five per cent bond is said to be sold on a four per cent basis. Its capital-value ($108.17), at the begin ning of the period represented (i.e., the value of a five per cent bond, valued on a four per cent basis), is obtained just as before, except that we now reckon by discounting at four per cent instead of at five per cent. Thus, in Fig ure 7, we see that the value of the bond, just before it be comes due, is $105, or AC; that its value one year earlier, just after the ninth interest payment, is A'B', or $105 + 1.04, or $100.96, and, just before the interest payment, is A'C', or $100.96 + $5, or $105.96; and so on back to its value at the beginning, MN, which is thus found to be $108.17. This is greater by $8.17 than the value of the bond as reckoned on the five per cent basis. The fact that four per cent has been used in our calculations instead of five per cent has made all of the discount curves less steep. We see, therefore, that nominally the rate of interest of the bond is not necessarily the actual rate of interest used in buying or selling that bond, and if the value of the bond is calculated on the basis of a rate of interest below the nominal rate of interest in the bond, the resulting value of the bond * Of course, the same result could be obtained by discounting separately at four per cent each of the eleven items to which the bondholder is en titled and adding the results together. The elements of which MN is composed may then be easily indicated just as, for the previous example, in Figure 6. SEc. 4) CAPITALIZING INCOME I2 I will be above par. Nominally the rate of interest is that named in the bond and, as previously noted, this is the actual rate of interest if the bond is worth par, but not otherwise. The actual rate is always that rate by which the actual value of the bond is calculated from the pay ments to which it entitles the holder. Tracing the history of the capital-value of the ten-year-five-per-cent bond reckoned at four per cent from the present toward the future, we may say that the rise in value during each ... Parn... yº. 92.61 Too FIG. 8. year is the interest accrued during the year on the capital value at the beginning of the year. Thus, the rise in value during the first year is four per cent of $108.17, or $4.32, and in the last year is four per cent of $100.96, or $4.038. It is also clear that the fall in the capital-value at I22 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI the end of each year (except the last), when the payment of the nominal interest is made, is exactly $5. That is, the income taken out each year is greater than the interest accruing during the year; hence the general decline in the capital-value of the bond. In the last year the income taken out is $105; although if the investor is wise, he will put back at least $100 into Some other bond or equivalent property. The reverse is true if the present value of the bond is calculated on a six per cent basis, or on any other higher than the five per cent named in the bond. Figure 8 repre sents the case of a five per cent bond valued on a six per cent basis. In this case the discount curves are steeper than in Figure 5, and the value of the bond at present, ten years before it becomes due, is $92.61. In Figure 8, as in the preceding diagrams, we know that the rise of capital value during any year is always the accruing interest on the capital-value at the beginning of that year. Thus, the rise in the first year will be six per cent of $92.61, that is, $5.55, and the rise during the last year will be six per cent of $99.05, namely, $5.95. It is also clear that the drop in capital-value at the end of each year is, as before, equal to the income taken out, or $5; that is, the income taken out each year is less than the interest accrued during the year; hence the general increase in the capital-value of the bond. It will be seen (as shown in the three figures, 5, 7, and 8) that the final value of the bond just before it becomes due will be $105 in all three cases, but that the present value is different in each case; namely, $100, $108.17, and $92.61. In each case the value zigzags year by year, but approaches in a general way $105 as its final value. If the “five per cent ’’ bond is sold on an actual five per cent basis, the value of the bond is maintained year by year, as seen in Figure 5, where the curve indicating capital-value runs in general horizontally; if it is sold on a four per cent basis, SEC. 4] CAPITALIZING I23 INCOME its value in general decreases, as shown by the descending trend of the curve in Figure 7; while, if it is sold on a six per cent basis, it tends to increase in value, as shown by the general upward trend in Figure 8. Elaborate tables have been constructed, called “bond value books,” calculated on the foregoing principles. They are used by brokers for indicating the true value of bonds on different bases; that is, the prices a man ought to pay for bonds, at different rates of interest and having different times in which to mature, in order to realize on them the market rate of interest. These tables are also used for solving the converse problem, viz., for finding the true rate of interest “realized” when a bond is bought at a given price. This rate realized will be the market rate, if the man has paid the right price, but sometimes he pays a wrong price. Given the market rate, we can deduce the right price to pay. Given the actual price paid, we can deduce the actual rate realized. The following table is an abridg ment of these brokers’ tables, for a five per cent bond. The prices of such a bond are in all cases the prices imme diately after an installment of interest has been received. In all cases the gradual increase in capital-value during any time is equal to the interest accruing during that time, while the sudden decrease at any time is equal to the value RATES OF INTEREST FIVE PER CENT BOND YEARS to MATURITY PRICE r 5 Io IO2 3.O IOI 4.O 4.6 4.8 4.9 IOO 5.o 5.o 5.o 99 6. I 5.2 5. I 98 7.I 5.5 5.3 4.8 I24 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI of the income taken out at that time. The only exceptions to these statements are when capital-value varies up or down because of changed opinion as to the chances of future in come; but we are here assuming that there are no uncer tainties to be reckoned with. From this table we see that if the so-called five per cent bond is sold at $102, and has one year to run, it will “yield” the investor three per cent; that is, if three per cent is used in calculating its value, this value will be $102. Again, if the bond has five years to run and is sold at $102, it will yield the investor 4.6 per cent; and if ten years, 4.8 per cent. If the bond is sold at $98 and has one year to run, it will yield the investor 7.1 per cent; if ten years, 5.3 per cent. If it is sold at par, it will yield five per cent, whatever may be the number of years it has to run. The same principles as have just been applied to valuing bonds apply also to valuing any other article of property or wealth. The student will find it a useful exercise to draw diagrams for other cases. He may construct a series of diagrams, the vertical lines representing the successive items of income expected, and beginning at the last item proceed backward year by year, by a series of teeth, to obtain the present value of the capital. The value of the capital must always befirst traced backward, but, after it has been obtained, we may retrace our steps. The zigzag curves which have been indicated for bonds and which could be constructed for exhibiting the valua tion of any other property right entitling the owner to definite sums of money or benefits of definite value at definite times are visual representations of the fact that the present value of any future benefit or collection of benefits gradually rises as the time grows near for their realization and suddenly falls as the realization occurs. The rate at which the value thus grows with time (between benefits-realized) is the rate of interest employed in these market valuations. SEC. s] I25 CAPITALIZING INCOME § 5. Effect of Changing the Rate of Interest From what has been said, it is evident that the value of any article of capital depends very greatly on the rate of interest. If there were no rate of interest, or if, in other words, the rate of interest were zero, the value of the capital would be simply the sum of the values of the anticipated benefits. In the case of the five per cent bond, for instance, running for ten years, if reckoned on a zero per cent basis, its value would be simply the sum of the $100 and the ten in terest payments, amounting to $50, or a total of $150. Since the rate of interest is always higher than zero, the value of the bond will always be lower than $150. To change the rate of interest will always change the value of capital in the opposite direction. For several generations the rate of interest has been falling, and consequently the value of bonds and of capital in general has tended to rise. Of course, the change in value of capital will be due also to many other circumstances than the change in the rate of interest, and, moreover, the effect of the change in rate of interest will not be the same on all articles of capital. For instance, the capital, the income from which is most remotely future, will be most affected. The following table shows the effect of lowering the rate | r carrº | Nºr is: º, year || 1: ‘àº'àº." $1ooo per yr. forever | Infinite $20,000.oo $1ooo per yr. for 5o yrs. $50,000.oo 18,300.oo Horse $1oo per yr. for 6 yrs. 6oo.oo 508.oo Suit of $20 1st yr.; $10 2d clothes | yr. . . . . . . 3o.oo 28.oo Loaf of $36.5o per yr., for I bread day . . . . . ..IO . IO Land House $40,000.oo 28,400.oo 55I.OO 29.Oo . IO * The figures in this table are worked out by the principle of discount ing previously explained. I 26 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VI of interest from 5 per cent to 2% per cent on five typical articles, whose incomes have different degrees of remote IneSS. If the value of the benefits derivable from these various articles continues in each case uniform, but the rate of in terest is suddenly cut down from 5 per cent to 2% per cent, there will result a general increase in the capital-values, but a very different increase for different articles. The more enduring ones will be affected the most. These effects are seen in the last two columns of the table. When the rate of interest is halved, the value of the land will be doubled, rising from $20,000 to $40,000, but the value of the house will rise by only about sixty per cent, namely, from $18,300 to $28,400; the value of the horse will rise only ten per cent, namely, from $508 to $551; the value of the suit will rise only from $28 to $29; and, finally, the value of the loaf of bread will not rise at all, but will remain at Io cents. We see from the changes in the values of these five types of articles that the sensitiveness of capital-value to a change in the rate of interest is the greater, the more remote the income. A high rate of interest requires a high premium on income near at hand as compared with income remotely future; or, expressed the other way about, a high rate of interest diminishes the attractiveness of remotely future income as compared with income close at hand. 4 CHAPTER VII VARIATIONS OF INCOME IN RELATION TO CAPITAL § 1. Interest Accrued and Income Taken Out WE have seen how the value of capital is derived from that of income. We have also seen that the value of capital rises in anticipation of income and falls after its realization. The alternate rise and fall may or may not be equal. From the principles explained it is evident that the rise of the capi tal-value as it ascends on the discount curve is equal to the interest accrued on that capital during that time, while the fall in that capital value due to the taking out of income is equal to the income taken out. If the income taken out is just equal to the interest, the capital is thereby restored to its original value. If more than this amount of income be taken out, the capital-value will be impaired, that is, made less than it was at the beginning of the period under considera tion; if less, the capital-value will increase. When a man is said to own a capital fund of $10oo, this means simply that he owns capital-goods worth that much; and these capital goods are worth that much simply be cause, in terms of money, the discounted value of the expected income from them is that much. The income which he expects may be a perpetual income flowing uni formly or in recurring cycles; or it may be an income like that from the bond, flowing recurrently for a limited time, at the end of which a large lump sum, ordinarily called the “principal,” is returned in addition; or it may be any one of innumerable other forms. Thus if we assume that five 127 I28 ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VII per cent is the rate of interest used in calculating the capital value, then any one of the following investments will have a present value of $10oo: a perpetual annuity of $50 per year; or an annuity of $50 a year for ten years, together with $10oo at the end of that period; or $100 a year for fourteen years, after which nothing at all; or $25 a year for ten years, followed by $167.50 a year for ten years, after which nothing at all; or any one of innumerable other forms. The student can easily prove that any one of these series of incomes, when discounted at five per cent, will make up a present value of $10oo. In the first case the income taken out ($50 a year) is exactly equal to the annual accrued interest, for $50 is the interest for one year at five per cent on $10oo. The same is true of the second instance mentioned, that of the five per cent bond, except in the last year when the income taken out ($1050) exceeds the interest for the year by $1ooo, thereby reducing the value of the bond to zero. In the third case the income taken out the first year is $100, while the interest accrued in that year is only $50. Thus the income taken out exceeds the accrued interest by $50. This excess of $50 involves a reduction of $50 in the capital-value of the property, which therefore becomes $950 instead of $10oo. Thus, at the end of the first year and after the $100 of income has been taken out, $950 is the discounted value of the remaining thirteen items of $100 a year for each year. In the second year the interest (on $950) is $47.50; whereas the income taken out is $100, the difference being $52.50. Hence, at the end of the second year, the capital-value of the remaining payments has been reduced by $52.5o, becoming $897.50. Similarly, the capi tal-value of the property decreases each year by the excess of the income over the accrued interest until the last in come item of $100 is received; after which, no more income being anticipated, the capital-value is zero. In the fourth case, the interest accruing during the first SEc. 2) VARLATIONS OF INCOME - I29 year is $50, whereas only $25 income is taken out at the end of the year, the difference being $25. Hence, at the beginning of the second year the capital-value of the bond goes up to $1025. During the second year, the interest (on $1025) is $51.25. After the receipt of the second income item of $25, therefore, the capital-value of the bond is in creased by the difference ($26.25) and becomes $1051.25. Similarly, the value of the bond increases until after the payment of the tenth income item of $25, when it becomes $1314.43. The interest on this amount in the eleventh year is $65.72; whereas the income taken out that year, and each of the remaining nine years, is $167.50. Hence, from the beginning of the eleventh year to the end of the twentieth, the capital-value of the bond decreases, finally reaching zero at the end of the period. The principle here shown may be summarized as follows: (1) When a property yields a specified foreknown income, and is valued by discounting that income at a specified rate of interest, if the income taken out is equal to the interest accrued, the value of the capital will be restored each year to the level of the year before. (2) If the income taken out exceeds the interest accrued, the value of the capital will fall below that of the year before, the amount of the fall being equal to the amount of the excess. (3) If the amount of in come taken out is less than the interest accrued, the value of the capital will rise above that of the year before, the amount the rise being equal to the amount of the deficiency. Briefly, the general principle connecting income taken out and interest accrued is that they differ by the net apprecia tion or depreciation of capital. It is thus possible to describe interest accrued as income taken out less depreciation of cap ital, or as income taken out plus appreciation of capital. § 2. Illustrations In order that these important relations may be as clear and vivid as possible, we shall illustrate them by concrete K I3o ELEMENTARY PRINCIPLES OF ECONOMICS (CHAP. VII examples, and by business accounting. The following table gives the income supposed to be taken out for five selected kinds of capital-wealth; the capital-value found by dis counting that income at five per cent; the accrued interest . for the first year; the resulting change or net appreciation or depreciation of capital-value; and the ratio of the first year's income to the original capital-value. The student will readily understand how the figures in the successive columns are calculated although the actual calculation of the third column (capital-value) from the second (income) is a tedious process involving in most cases the discounting of a large number of separate items. * CAPITAL- Income TAKEN out WEALTH PER YEAR Cº(I NT. At 5%) INCREASE INTEREST | (+) or DEAccRUED | CREASE (–) For FIRST of CAPITAL YEAR VALUE. In FIRST YEAR r RATIo of FIRST r tºo ORIGINAL CAPITAL r value Forest land $1ooo a yr. for I4 yrs. and % then $3000 a yr. forever . $40,000.ool $2000.ool--$1ooo.o.o. 2.5 Farm land $1ooo per yr. forever . . . 20,000.ool Iooo.oo o.OO 5.o House $1ooo per yr. for 50 yrs. . 18,300.ool 915.ool -85.oo 5.4 Horse $1oo per yr. for 6 yrs. . . 508.oo 25.40 –74.60. 19.6 Suit of $20 1st yr.; $10 clothes 2d yr. . . 28.oo I.4O – 18.60 71.4 1. The forest land yields $1ooo worth of income the first year on a capital-value of $40,000, from which, on the five per cent basis assumed, the interest accrued would be five per cent of $40,000, or $2000. Consequently, the income taken out ($1ooo) is less than the interest accrued ($2000) by $10oo. Therefore the forest will appreciate in the year by the excess, $2000 – $10oo, or $10oo, and will be worth $41,000 at the end of the year. Similarly, it will continue Sec. 2) VARIATIONS OF INCOME I31 to appreciate for fourteen years, when it will be worth $60,000; after which the income that is annually taken out ($3000) will be equal to the annual accrued interest on $60,000. 2. The farm land yielding $10oo a year in perpetuity is, on the five per cent basis, worth $20,000, and continues to be worth that amount each succeeding year. The income taken out ($10oo) is always equal to the interest accrued from $20,000. 3. The house yields an income of $10oo on a capital value the first year of only $18,300. The interest accrued on $18,300 would be five per cent of $18,300, or only $915. The consequence is an excess of income taken out over interest accrued of $10oo — $915, or $85, and a corresponding fall of $85 in the value of the capital. That is, the house depreci ates by $85 in the year, or from $18,300 to $18,215. It will continue to depreciate each year until its value vanishes entirely at the end of fifty years. 4. The horse also depreciates, and very fast. It