• TABLE OF CONTENTS
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 Title Page
 Preface to the first edition
 Preface to the re-issue
 Preface of the reprint of 1948
 Preface of the reprint of 1957
 Table of Contents
 Part I: Introductory
 Part II: Perfect competition
 Part III: Imperfect competition...
 Index
 Advertising






Group Title: London School of Economics and Political Science. Series of reprints of scarce tracts in economics and political science. No. 16
Title: Risk, uncertainty and profit
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 Material Information
Title: Risk, uncertainty and profit
Series Title: London School of Economics and Political Science. Series of reprints of scarce tracts in economics and political science. No. 16
Physical Description: 381 p. 23 cm.
Language: English
Creator: Knight, Frank Hyneman
Knight, Frank H.
Publisher: London School of Economics & Political Science, University of London
Publication Date: 1957
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Spatial Coverage: Europe -- England -- London -- Britain
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General Note: Originally published, Houghton Mifflin Co., 1921.
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Holding Location: George A. Smathers Libraries, University of Florida
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Resource Identifier: oclc - 30234617

Table of Contents
    Title Page
        Page i
        Page ii
        Page iii
        Page iv
        Page v
        Page vi
    Preface to the first edition
        Page vii
        Page viii
        Page ix
        Page x
    Preface to the re-issue
        Page xi
        Page xii
        Page xiii
        Page xiv
        Page xv
        Page xvi
        Page xvii
        Page xviii
        Page xix
        Page xx
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        Page xxii
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        Page xxiv
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        Page xxix
        Page xxx
        Page xxxi
        Page xxxii
        Page xxxiii
        Page xxxiv
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        Page xxxvi
    Preface of the reprint of 1948
        Page xxxvii
        Page xxxviii
        Page xxxix
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        Page xlvi
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        Page l
        Page li
    Preface of the reprint of 1957
        Page lii
        Page liii
        Page liv
        Page lv
        Page lvi
        Page lvii
        Page lviii
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    Table of Contents
        Page lxiii
        Page lxiv
        Page lxv
        Page lxvi
    Part I: Introductory
        Page 1
        Page 2
        The place of profit and uncertainty in economic theory
            Page 3
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        Theories of profit; change and risk in relation to profit
            Page 22
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            Page 48
    Part II: Perfect competition
        Page 49
        Page 50
        The theory of choice and of exchange
            Page 51
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        Joint production and capitalization
            Page 94
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        Change and progress with uncertainty absent
            Page 141
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        Minor prerequisites for perfect competition
            Page 174
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    Part III: Imperfect competition through risk and uncertainty
        Page 195
        Page 196
        The meaning of risk and uncertainty
            Page 197
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        Structures and methods for meeting uncertainty
            Page 233
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        Enterprise and profit
            Page 264
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        Enterprise and profit (continued) the salaried manager
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        Uncertainty and social progress
            Page 313
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        Social aspects of uncertainty and profit
            Page 347
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    Index
        Page 377
        Page 378
        Page 379
        Page 380
        Page 381
    Advertising
        Page 382
Full Text








RISK, UNCERTAINTY AND PROFIT











The London School of Economics and Political Science
(UniversitQ of London)
Houghton Street, Aldwych, Lonfdon, W .C.2


No. 16

In Series- of Reprints
of Scarce Tracts in Economic and Politicnl Science

RISK, UNCERTAINTY AND PROFIT

With an additional introductory essay hitherto unpublished

by FRANK H. KNIGHT, Ph.D.
Professor of Economics in the University of Chicago


FIRST H REPItNTRE)
SECOND) IMPRIE.SION
THIRD IM PI'llM ION
FOURTH IMPRESSION
FIFTH I IMPRESSION
SIXTH IMPItESSION
SEVENTH IMPRESSION
1EI(HTII IMPIREtSSION

























EDITORIAL NOTE

This work was first published in 1921, as number xxxi in
Messrs. Hart, Schaffner and Marx' series of prize essays on
economics. For several years before 1933 it was out of print
and Messrs. Hart, Schaffner and Marx, the owners of the
copyright, generously granted permission for its inclusion in
the present series. The editors wish to acknowledge their great
indebtedness to the distinguished author, Professor Knight, for
providing additional embellishments in the shape of the
extensive preface, virtually an additional chapter to the
original work, which he wrote for the 1933 Reprint, and the
1948 and 1957 Prefaces also included in the present Reprint.








RISK, UNCERTAINTY

AND PROFIT



BY
FRANK H. KNIGHT, PH.D.
ASSOCIATE PROFESSOR OF ECONOMICS IN THE STATE UNIVERSITY
OF IOWA


BOSTON AND NEW YORK
HOUGHTON MIFFLIN COMPANY
ltbe ftitoreribe prejl Cambribt
1921































COPYRIGHT, 192a, BY HART, SCHAFFNER & MARX

ALL RIGHTS RESERVED INCLUDING THE RIGHT TO REPRODUCE
THIS BOOK OR PARTS THEREOF IN ANY FORM


Reproduced by photo-lithography and made at the Pitman Press, Bath














PREFACE TO THE FIRST EDITION

THERE is little that is fundamentally new in this book. It
represents an attempt to state the essential principles of
the conventional economic doctrine more accurately, and
to show their implications more clearly, than has previ-
ously been done. That is, its object is refinement, not re-
construction; it is a study in "pure theory." The motive
back of its presentation is twofold. In the first place,
the writer cherishes, in the face of the pragmatic, philistine
tendencies of the present age, especially characteristic of
the thought of our own country, the hope that careful,
rigorous thinking in the field of social problems does after
all have some significance for human weal and woe. In the
second place, he has a feeling that the practicalismm" of
the times is a passing phase, even to some extent a pose;
that there is a strong undercurrent of discontent with loose
and superficial thinking and a real desire, out of sheer in-
tellectual self-respect, to reach a clearer understanding of
the meaning of terms and dogmas which pass current as
representing ideas. For the first of these assumptions a few
words of elaboration or defense may be in place, in antici-
pation of the essay itself.
The "practical" justification for the study of general eco-
nomics is a belief in the possibility of improving the qual-
ity of human life through changes in the form of organiza-
tion of want-satisfying activity. More specifically, most
projects of social betterment involve the substitution of
some more consciously social or political form of control for
private property and individual freedom of contract. The
assumption underlying such studies as the present is that
changes of this character will offer greater prospect of pro-
ducing real improvement if they are carried out in the light








PREFACE


of a clear understanding of the nature and tendencies of
the system which it is proposed to modify or displace. The
essay, therefore, endeavors to isolate and define the essen-
tial characteristics of free enterprise as a system or method
of securing anddirectingcobperative effort in a social group.
As a necessary condition of success in this endeavor it is
assumed that the description and explanation of phe-
nomena must be radically separated from all questions
of defense or criticism of the system under examination.
By means of first showing what the system is, it is hoped
that advance may be made toward discovering what such
a system can, and what it cannot, accomplish. A closely
related aim is that of formulating the data of the problem of
economic organization, the unchangeable materials with
which, and conditions under which, any machinery of or-
ganization has to work. A sharp and clear conception of
these fundamentals is viewed as a necessary foundation for
answering the question as to what is reasonably to be ex-
pected of a method of organization, and hence of whether
the system as such is to be blamed for the failure to achieve
ideal results, of where if at all it is at fault, and the sort.
of change or substitution which offers sufficient chance for
improvement to justify experimentation.
The net result of the inquiry is by no means a defense of
the existing order. On the contrary, it is probably to em-
phasize the inherent defects of free enterprise. But it must
be admitted that careful analysis also emphasizes the fun-
damental difficulties of the problem and the fatuousness
of over-sanguine expectations from mere changes in social
machinery. Only this foundation-laying is within the scope
of this study, or included within the province of economic
theory. The final verdict on questions of social policy
depends upon a similar study of other possible systems of
organization and a comparison of these with free enterprise
in relation to the tasks to be accomplished. This one "con-
clusion" may be hazarded, that no one mode of organiza-








PREFACE


tion is adequate or tolerable for all purposes in all fields.
In the ultimate society, no doubt, every conceivable type of
organization machinery will find its place, and the problem
takes the form of defining the tasks and spheres of social
endeavor for which each type is best adapted.
The particular technical contribution to the theory of
free enterprise which this essay purports to make is a fuller
and more careful examination of the role of the entrepreneur
or enterpriser, the recognized "central figure" of the sys-
tem, and of the forces which fix the remuneration of his
special function. The problem of profit was suggested to
the writer as a suitable topic for a doctoral dissertation
in the spring of 1914 by Dr. Alvin Johnson, then Professor
of Economics in Cornell University. The study was chiefly
worked out under the direction of Professor Allyn A. Young
after Dr. Johnson left Cornell. My debt to these two teach-
ers I can only gratefully acknowledge. Since the accept-
ance of the essay as a thesis at Cornell in June, 1916, and
its submission in the Hart, Schaffner & Marx competition
in 1917, it has been entirely rewritten under the editorial
supervision of Professor J. M. Clark, of the University of
Chicago. I have also profited much by discussions with
Professor C. O. Hardy, my colleague at the same institu-
tion, and by access to his unpublished "Readings on Risk
and Risk-Bearing." Professor Jacob Viner, of the Uni-
versity of Chicago, has kindly read the proof of the entire
work. My obligations to various economists through
their published work are very inadequately shown by
text and footnote references, but are too comprehensive
and indefinite to express in detail.
F. H. KNIGHT
Iowa City, Iowa
January, 1931















PREFACE TO THE RE-ISSUE


THIS essay having gone out of print, the London School
of Economics has done its author the signal honour of
including it as a number in its series of reprints. In
addition, I am accorded the privilege of writing a new
preface. Rather than undertake to bring the book
down to date in detail, or even to correct mistakes, I am
disposed to use this occasion to offer a few comments
on the type of economic theory it represents and the
lines along which received economic doctrine seems to
me to need development and modification, assuming
that such endeavour is to be carried on. There are
several statements I want placed before any reader
of the book under a present date.

I
In the first place, as the contents show, I have from
the beginning of my concern with economics been
especially interested in the implications of theory, the
postulates necessary for theorizing, and hence the
divergences between theoretical conditions and reality.
This interest has grown through the years since 1915-16,
when most of the work was first written, as a doctoral
dissertation at Cornell University. These years have
been spent in giving courses in "theory" to university
classes. The period has, notably in the United States,
been one of general if rather blind revolt against
"classicism." This environment, together with the
consequences of the popularity of economics and the
effort to teach it to a general mass of students without
scientific or social interests, and in addition the








xii PREFACE TO THE RE-ISSUE
political drift in the European-democratic world away
from Liberalism and all its works-all has been
stimulating to reflective questioning. It has been my
special endeavour to clarify to myself the various
possible "approaches" to economics, the subject of so
much confused discussion. The result, rather terrible to
confess, is something of the order of a "system" of
methodology, or rather, methodologies. Though the
proposal to replace price-theory economics with some
other study seems indefensible, I am in sympathy with
the reaction against it to the extent of wishing to see it
expounded in integral connection both with emphasis
on what it does not do as well as what it does, and with
an adequate survey of what other types of treatment of
the same general subject-matter have to offer.
Economic theory based on utilitarian premises,
which is to say all "economic" theory in the proper
sense of the word, is purely abstract and formal,
without content. It deals, in general, with certain
formal principles of "economy" without reference to
what is to be economized, or how; more specifically,
price-economics deals with a social system in which
every individual treats all others and society merely as
instrumentalities and conditions of his own Privatwirt-
schaft, a mechanical system of Crusoe economies. It
discusses the use of given resources by given "owners,"
in accord with a given system of technology, to satisfy
given wants, all organized through a system of perfect
markets. Any question as to what resources, techno-
logy, etc., are met with at a given time and place,
must be answered in terms of institutional history,
since all such things, in common with the impersonal
system of market relations itself, are obviously culture-
history facts and products. (It is true that in some
sense and some degree "economic" motivation and
process, meaning the effort to secure maximum results








PREFACE TO THE RE-ISSUE Xiii
of a given kind from given resources through correct
allocation among alternative channels of use each
subject to "diminishing returns," may enter into
culture-history.-Cf. below, p. xviii.)
But there is another and deeper sense in which price-
theory data are inherently without content, as regards
the wants which drive the system. For such a treat-
ment, these must be viewed as wants for the goods and
services produced, bought and sold, and consumed.
But such wants are in a vital sense unreal as well as
abstract. Commodities and services are in a very
limited degree wanted for their intrinsic properties;
in the main they are symbolic of ends the substance
of which is a social relation or ideal value. The
classical economists fell into two disastrous errors
(the other to be noticed later) connected with taking
food and eating as the type of economic interest.
Eating itself is, in fact, a highly social interest, and the
least consideration of, say, clothing, not to mention the
"higher" wants, would have given a very different
colour to the treatment. Of course people want
nourishment and certain requirements for physical
comfort, but the means actually desired for meeting
even such needs depend on social standards historically
formed. In the great bulk of wants satisfied through the
market, a desire for "goods and services" because of any
intrinsic quality is a minimal element. Any realistic
treatment of economic life, especially with reference to
its problems, calls for recognition of a fairly clear scale
of motivation, the strata of which range away from the
purely economic level where physical means are used
to realize ends which are quantitatively a function of
the means employed. A brief and partial list will
indicate the nature of the scale.
As compared with subsistence and comfort, a much
larger element in wants is esthetic. The degree to








Xiv PREFACE TO THE RE-ISSUE
which asthetic appeal depends in some universal way
on intrinsic quality, how far it goes with the stable
features of a culture, how far it is a matter of fashion
or socio-historical accident, has long been for me
one of the most fascinating questions lying hardly
below the surface of economic discussion. Largely
overlapping with the aesthetic element in wants are
the purely "social" wants merely symbolized by
particular economic goods, as the desire to win in a
game centres in points or pieces. Social wants fall
largely under such polarized forms as conformity and
distinction, freedom and power, never clearly separable
in analysis. Another element is the desire to make an
impression, ranging in form from angel to devil or as
widely along intersecting scales, or the form may be
indifferent. Less directly social elements in motivation
also refuse to fit the economic pattern. Such are the
appeal of familiarity and of novelty, the interest in
activity and achievement with the particular content
accidental, and the element of uncertainty affecting a
wide range of interests. (In this connection I still find a
fundamental significance in the analysis of uncertainty
in the essay, and am puzzled at the insistence of many
writers on treating the uncertainty of result in choice
as if it were a gamble on a known mathematical
chance; in particular, I may remark that I can make
no sense at all of Professor Pigou's treatment of un-
certainty as a factor, in the first appendix of the
Economics of Welfare-or indeed, of his general concep-
tion of a factor.)
Finally, of greatest practical significance among non-
rational elements in motivation is the factor of valua-
tion. It seems to me that a large part of deliberate
action is affected with a desire to be right or correct in
some sense. But the wish to get the right, or best
possible solution of a problem cannot be classed with








PREFACE TO THE RE-ISSUE XV
desires for a specific result; when interested in a problem
one does not even wish someone else to give him the
right answer. The consequences for economic theory
are far-reaching. It must deal with ends of action in
some sense or lose all connection with the concept of
economy, to say nothing of relevance to economic
problems. But the only conception of end which can be
regarded at all in the light of a scientific datum is a
desire for a describable thing or situation existing in an
individual mind. Now several lines of social-psycho-
logical theory converge in the view that most conscious
desire is ultimately a wish to play a r6le, to be some
kind of a person in some kind of a human world. It has
already been indicated that ideals of personality and
society cannot be described in terms of physical con-
figuration, hence cannot be brought into that realm of
subject-matter Which is so recognizable from descrip-
tion as to be called "science." Such content belongs
rather to a universe of meanings and values (whether
good or bad, wise or stupid, is not in question).
But that is by no means the end of the difficulty.
It is equally important for any social theory to recognize
that there is a kind of description of such matters, which
is not scientific in the natural-science sense, and to be
clear that discussion has to go forward into an even
more intellectually troublesome field. As soon as such
ideals begin to be discussed, there is an appeal to norms
having an imperative quality, an element of problem-
solving on a normative or moral level. For discussion
of ideals cannot be confined to pure description,-such
description as is possible. Indeed the same is true in a
different sense of all science; it describes what an
observer ought to see, what he will see if he sees
correctly; the alternative is pure self-revelation, mental
undressing, and any interest attaching to it is literary,
not scientific. Correspondingly, any social science








XV1 PREFACE TO THE RE-ISSUE
implies recognition of and dealing with "real social
values." The significance of all this is that economics
cannot be economic without being both political and
ethical. Such approach to scientific quality as is
possible is to be achieved by striving for a clear relation
between description and evaluation at different levels.
The difficulty here is that the tendency of expositors
is in the opposite direction; one interested in facts is
impelled to re-enforce truth with practical relevance,
and one interested in policy tries to strengthen his
appeal by giving his statements the colour of scientific
objectivity. It is little wonder that economic theory
has been slow in straightening out the relations
between price and value or between analysis and
propaganda.
On the basis of different conceptions of behaviour,
or different aspects of or elements in behaviour which
may receive more or less exclusive attention, there are
some half-dozen main types of treatment of economic
phenomena. (I) A statistical study of the physical
data, commodities and prices, with subjective or human
elements left out. Such a discussion is only by implica-
tion economics, and cannot be literally carried out,
since uses as well as physical properties inevitably enter
into the classification of commodities. (2) Treatment
in terms of motivation considered as fact. This is the
conception more or less closely approximated in
traditional economics, disregarding political exhorta-
tion by the authors. But since motives can only be
objectively defined and classified with relation to
observed results of action, this method runs into the
first if it pretends to literal objectivity. If it does treat
motives realistically, it must recognize that they are
abstract, relate to social patterns, and differ from
actual behaviour through error in a two-fold sense,
.error in reaching a goal and error in conception of the








PREFACE TO THE RE-ISSUE xvii
goal itself. (3) Recognition of other elements in
motivation, social-symbolic, ethical, etc., will make the
treatment more realistic and true in a human sense,
less scientific in the sense of the objective sciences
of nature.
(4) The procedure of No. 3 runs inevitably into
considerations of social policy, but in such treatment
there is a kind of objectivity possible, policies and
results being treated as facts. However, the conceptions
are far from those of natural science, since the proce-
dures dealt with are essentially rules of the game and
the results different kinds of game or social constitution.
The instrumentalism of science would conceive of each
individual as pitted against all others in an endeavour
to manipulate them to his private ends. This cannot
be done by "scientific" methods, for the technique
takes mainly such forms as coercion, persuasion, and
deception, which have no meaning in the relations of
men to natural objects. The character of social result
implied needs no comment. (5) Outright preaching or
propaganda for any social policy which the author
considers desirable or desires. It is a matter of life and
death for economics as a science in the limited sense
possible to keep the desired and the desirable separate,
but the tendency is rather toward confusing them. In
connection with (4) and (5) it is also vital to preserve
the distinction between objectives in a fairly concrete
sense and objectives in the form of social relations.
The treatment of one such abstract relation, namely
Liberty, played havoc with the conceptions of the
classical economic tradition. These writers not merely
confused propaganda for liberty with analysis of a free
system but conceived of liberty in a largely erroneous
way as a means, with maximum pleasure as the end.
Liberty may be and certainly is desired by men apart
from any belief that they will make their decisions








PREFACE TO THE RE-ISSUE


more wisely than might be done for them, from the
standpoint of their own economic well-being. Just as
obviously, liberty may be treated as a value, a duty, and
all modern Western legal systems do so treat it, in
prohibiting the individual from contracting it away.
(In addition, liberty may be advocated, within wide
limits, as an alternative to the government crippling
itself for possible useful functions by attempting what
it cannot perform.) The classical thinkers also tended
to forget that economic liberty is freedom to use
economic power and that consequently its content may
range from slavery to enslavement of others, depending
on the distribution of economic power. They even
appealed to the desire of every man to better his
condition, including that of his heirs, without noticing
that freedom to use power to get more power involves a
cumulative tendency to inequality.
(6) A heterogeneous group of "approaches" results
from centreing attention on history and historical
causality. As already noted, this standpoint is involved
whenever the exposition passes beyond the abstract
assumptions of a stationary economy to treat of content
or change in content. It is, indeed, common to appeal
to economic motivation to explain historical change,
this being the first article of the creed which has come
to be called Marxism, so largely swallowed by historians
who have never worked critically with economic
concepts. (While historians preach an economic
interpretation of history, economists work toward a
historical interpretation of economics, somewhat as
many psychologists are eighteenth-century materialists,
while physicists grow rationalistic, idealistic and
romantic.) In brief, changes in conditions affecting
economic life can themselves be explained in economic
terms if and insofar as they are the result of "rational"
abstinence (not "waiting") and investment. This


xtiii








PREFACE TO THE RE-ISSUE XIX
applies to the three fields of change, affecting wants,
resources and technology. It is not without meaning to
view the balancing of present against future as similar to
any other economic comparison. But in addition to all
the limitations on the economic view of motivation
already noted, sacrifice of present to future necessarily
means sacrifice of a fairly immediate, definite, pre-
dictable, and secure future for one the opposite in all
these respects, and known to lie chiefly beyond the
life-time of the person making the choice. Economic
development involves the permanent conversion of
"present goods" into income, really a large income for
a short period into a small one in perpetuity. It is
doubtful whether the interest in the future "as a whole"
can be considered as economically rational at all, and
it is certain that such an interest plays little if any r6le
in actual saving and investment; the real motives in
this case are almost or quite entirely what the real
motives of consumption are largely, i.e., symbolic and
abstract.
I must regard it as one of the major errors in the
classical tradition that it failed, and still largely fails,
to make a sharp and correct theoretical distinction
between the working of a system under given con-
ditions, including movement towards equilibrium,
and changes in the given conditions or content of the
system itself. This is reflected in the current misleading
use of the concept of economic dynamics to refer to
such historical changes; it can properly refer only to
the movement of a system toward equilibrium under
given conditions. A related error is the treatment of
historical changes as tending toward an equilibrium.
None of them do so in the proper meaning of the words
-a statement which may be taken as a definition of
historical change, though the idea of irreversibility is
also involved. Historical changes are rather, in general,








XX PREFACE TO THE RE-ISSUE
self-aggravating or cumulative. Progress (in any
direction) opens the way to further progress, unless
some cataclysm or the mysterious moral phenomenon
of decadence intervenes. (Historical change should not
be referred to as growth-as I have carelessly done-
without pointing out that it involves growth in two
rather definitely opposed lines, wants and level of
provision; it is not possible to define objectively a fixed
total of either, but it is none the less necessary to
distinguish analytically between a change in the total
and a change in form or direction with total unchanged.)
II
Turning briefly to the detailed content of price
theory in its application to a historically stationary
economy, I should like to note a few ways in which I
think the material might be made more sound,
realistic and relevant than it generally is. (Many of
the points have received notice in print, by myself and
others, but are. not incorporated into the accepted
fundamentals; I disclaim originality-anything very
original in economics would be wrong anyway-but
since such considerations are more regarded than
they ought to be, and readers may be reminded of
recent discussion, I may say that this is the line along
which I have presented the subject for a dozen or
more years.)
I. Nearly all suppliers of economic goods and
services, outside of a few fields in which the identity of
the seller is lost or production is according to specifica-
tions, enjoy some degree of monopoly. Each has a
monopoly within a certain market area, and competition
is effective only at the boundary between market areas.
The condition of equilibrium is equality between
incremental cost and incremental revenue; price,
which is to say product (see below) may or may not be








PREFACE TO THE RE-ISSUE xxi
classified within the market area. (a) A supplier is a
business unit, or firm, individual or corporate, which
must not be confused with the technical unit, or plant
(contrast Pigou, Ec. of Welfare, p. 219). The size and
scope of the plant is a technical detail to the business
unit, like any other phase of machine or building
design. The relation between efficiency and size of
firm is one of the most serious problems of theory,
being, in contrast with the relation for a plant, largely a
matter of personality and historical accident rather
than of intelligible general principles. But the question
is peculiarly vital, because the possibility of monopoly
gain offers a powerful incentive to continuous and un-
limited expansion of the firm, which force must be
offset by some equally powerful one making for
decreased efficiency (in the production of money
income) with growth in size, if even boundary com-
petition is to exist. (b) A firm expands along several
dimensions or axes, and theory stands in need of a
development of the concept of market area or field of
demand and supply. The detail of geographical area
has received some attention, rather superficial as I
view it; but more important is a commodity or service
area, a "utility surface" in another than the usual sense.
As a matter of fact, a commodity must be defined by
defining its market area (or the other way); all costs,
including transportation and every sort of selling cost,
correspond to dimensions in a commodity, and the
dimensions of a firm are found by summating those of
whatever products it sells either at different prices or
under different names. (c) Generally speaking, the
expansion of a firm (involving more or less change in
size and re-spacing in various dimensions of its technical
units) cannot be represented by a reversible functional
relation; in consequence, real equilibrium will depend
on all the accidents and errors of the process by which








XXii PREFACE TO THE RE-ISSUE
it is reached as well as on the conditions to which final
adaptation is made.
(2) Current interest in monetary and trade cycle theory
brings out a major omission in the standard presentation
of economic theory; it is one scientifically defensible, to
be sure, but practically serious since even professors of
economics, to say nothing of the public, do not generally
have scientific minds. In any case, the situation under-
lines the need for emphasis on the theoretical difficulties
of money. If the exchange-medium of a society has no
intrinsic service value, the velocity of circulation must
approach infinity, as the amount of uncertainty
affecting the individual's need for money is reduced
toward zero; if it does have independent utility, its
value will approach that as a limit.
(3) The notion of equilibrium is one taken from
mechanics, and its use in economics carries the assump-
tion that all the cause-and-effect relations of the
system can be represented by a set of simultaneous
equations. But to be meaningful, such equations must
be "dynamic" in the correct sense of the word; they
must embody some process of movement toward
equilibrium and not merely describe conditions at
equilibrium; they must be analogous to equations of
motion. This calls for actual, continuous simultaneity
of cause and effect in every relation expressed. That
the facts do not fit such assumptions is obvious enough,
and, more important for theory, it leads to a muddle
in the conception of the dimensions of economic
magnitudes. Most of the content of economic theory
must relate to lags between cause and effect, and these
are not got rid of by any juggling of concepts on the
pattern of acceleration in mechanics, and still less are
they adequately dealt with on the pernicious analogy
of "friction," which covers so many sins in economic
thought.








PREFACE TO THE RE-18SUE


The entire application of mechanical categories to
economic analysis requires drastic overhauling, but
only the barest intimation of the problems of a realistic
economic dynamics can be given here. There is nothing
in economics corresponding to either momentum or
energy, or their conservation principles in mechanics;
of the three basic dimensions of mechanical process
only time is real for economics; there is no definable
economic space (hence no direction or velocity), and
no mass. Yet the notions of force and resistance in a
more or less quantitative sense are unavoidable in
interpretirig the phenomena-much more so indeed
than in mechanics itself-and the same is true of
equilibrium. There can be no question of a real
tendency toward equilibrium in detailed relationships,
or even apparently in the system as a whole. There is
also something more or less like inertia and friction,
though it must be inertia without mass and friction
without energy transformation. The force and resistance
relations in the movement toward equilibrium are on
one side mental, affecting the learning process (elimina-
tion of "error") in the minds of consumers, managers
and owners of productive resources. This must be
broken down into the learning of new processes of
realizing ends and the very different "learning" of new
ends (a historical change), yet with no clear line
between the two. On the side of action, there is a kind
of "viscosity" which is in part a matter of the cost of
making physical changes being dependent on their
speed and in large part a matter of a more or less
definite replacement period for physical items, more or
less applicable to human beings. (The service life is
largely dependent on expectations at the time commit-
ments are made and during the period of use, and, to
repeat what was just said in another connection,
economic equilibrium is always a function of the


XXiii








XXiv PREFACE TO THE RE-ISSUE
accidental details of the process of establishing it, as
well as of the governing conditions at the end.)
Even superficial study of mechanical principles
suggests many possibilities of oscillations, damped or
undamped. A careful working out of the parallelism
ought to shed light on economic cycles, and, in
combination with monetary theory, on "the" business
cycle.
4. The next heading to be mentioned ties up with the
question of dimensions from another angle, and
relates to the second main error mentioned earlier as
connected with taking food and eating as the type of
economic activity. The basic economic magnitude
(value or utility) is service, not good. It is inherently a
stream or flow in time, and becomes an absolute
quantity, in which form it generally appears in ex-
change, only through a two-fold process of (a) integrating
over time, and (b) capitalizing. Where the turn-over
period or life of an item under a certain form and name
is very short, as in the case of foods, no important error
results from identifying the good with its service-
except that such materials are really the embodiment
of accumulated services of persons and durable goods.
But in theory, all wealth is homogeneous capital
(except at the mathematical limit of infinitely durable
goods once in existence); the quantity in any item
depends on its net income yield after provision for
perpetual maintenance (and replacement) and on the
rate of interest; the service life is a detail in the calcula-
tion, as is also the form with which the item is to be
replaced, if it is to be replaced. The rate of capitaliza-
tion (interest rate) is determined by the expected
productivity of new investment. I am convinced that
less damage has been done to economic thinking by
any other single error, unless it be that of labour cost,
than by the notion of production as production of








PREFACE TO THE RE-ISSUE XXV
wealth; production is the rendering of service, by
goods (wealth) and by persons; net additions to or
subtractions from wealth (capital) must be marked out
through a sharp separation of maintenance (and re-
placement) from income, in accord with the only
possible accounting procedure. It would, indeed, be
still better if, by the use of distinctive terms net change
in capital wealth could be set apart from production
and incomecorrelative with consumption.
5. Last under these questions of mere accuracy of
formulation, we still have with us a distressing burden
of the false fundamentals of the classical (meaning
pre-Jevons-Menger) system. Such are cost as absolute
instead of relative (when said to determine price);
wages, interest and rent as distributive shares; payment
for sacrifice, instead of for service; factors of production,
instead of concrete agencies (free human beings and
owned agencies) on one hand, and abstract capital in
owned agencies on the other; also, the more modern
but equally pernicious notion of utility, if given any
meaning but the purely abstract effective motivating
power in a unit of (commodity or) service; and more
such antiquated lumber.

III
Having started out by insisting on the necessity for
economics of some kind of relevance to social policy-
unless economists are to make their living by providing
pure entertainment or teaching individuals to take
advantage of each other -I must in closing set down a
few observations on the conditions of relevance. These
observations cannot be very optimistic, from the stand-
point of the prospects of economics in the traditional
form, or that of'the values which the age of liberalism
thought the main historical achievements of the race.
Looking at the recent course of governmental policy,








XXVI PREFACE TO THE RE-ISSUE
in the home-land of free trade and elsewhere, one is not
encouraged as to the prospect of governments being
guided by economists or by sound economics, meaning
actually "economical" principles. Looking at pub-
lished economics as a whole in the same period, it is
impossible, for me, at least, either to find mystery or to
feel regret as regards the first part of the proposition.
But, looking deeper at the realities of social life and its
problems, there is no longer any mystery-however
one may feel about it-either in the progressive
degradation of the text-books and literature by which
the public judges our profession, or in the movement
away from "liberalism and all its works" referred to
at the outset.
The first and main suggestion, looking towards a
more relevant economics, is that the inquiry into
motives might well, like charity, begin at home, with a
glance at the reasons why economists write books and
articles. These things are also commodities, produced
competitively for a market, and the traffic contains
pointed indications at the nature and relative im-
portance of consumer and producer interests in the
wider field. In addition, the behaviour of economists
provides evidence regarding the possibilities of settling
questions-and of settling them rightly-by free
discussion.
Economics finds itself in a vicious circle. To get
recognition and have influence, it descends to the
public's level of thinking; then competition for re-
cognition and influence take the place of the effort to
get things straight; finally, success in this competition
becomes the condition of membership in the profession
itself. It is no doubt idle to say, now, that there "might
have been" an economics profession made up of minds
exclusively devoted to the problem-solving interest and
working co-operatively at this task, instead of more and








PREFACE TO THE RE-ISSUE


more hawking their wares competitively to the public
by way of settling their "scientific" differences.
Whether such a profession might have exercised social
leadership, rather puts the same question in a general
form and brings out an essential contradiction in the
notion of leadership in a "free" society. If the crowd
selects its leadership by acting as judge in an open
competition for the place, then the crowd is its own
leader, which is the literal meaning of democracy, and
the thinking which directs affairs is crowd thinking.
The r6le of the individual is limited to suggesting and
competitively promoting ideals and programmes-if
even such activity can really originate in an
individual.
It is not easy to see, at this date, just what was the
nature of the Enlightenment faith in popular govern-
ment. Perhaps the main ingredient was a belief that the
religion of property and a free market was too obviously
"the truth" ever to be seriously questioned, and that it
would reduce the of r6le government to negligible
scope. Insofar as it was a faith in mass decisions in any
sense, the more or less defensible element seems to have
centred in the ability of the mass bf men to judge
personality, as to honesty and competence, an essen-
tially mystical faculty of "liking" the proponents of
right procedures to right ends rather than those
opposed, without understanding the arguments in-
volved. At best it would seem to be necessary that the
contest should take the form, in the main, of some
kind of serious treatment of issues, rather than pure
oratory, buffoonery or bribery. But in the nature of
the case, the crowd must determine the form of the
contest as well as judge the winner. The techniques
employed by the contestants will be those which
"work." (But perhaps the democratic faith was itself
a mere case of crowd-thinking, for which it is as futile


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PREFACE TO THE RE-ISSUE


to seek an intellectual basis as in the case of any fashion
or craze.)
The one thing clear now is that crowds "think" very
little if at all, in the sense of impartial analysis or
criticism. And this is notably true under the conditions
of a political campaign, and one of the results of
modern technology is to give the governing process
much of the character of a continuous campaign, the
first principle of which is to create the crowd-mind.
Anything that appeals to the crowd-mind must be
simple and romantic; its favourite formula is credo quia
impossible, its favourite policy, witch-hunting. It cannot
be expected to show anything but contempt for "sound
economic theory," and indeed its thinking on such a
primitive issue as criminology is no better. But, the
question once raised and general discussion started,
there is no possibility of its "turning itself off," no
chance of going back to unthinking acceptance of
leadership as it happens. Democracy must go through
to its inherent limit, or revert to tyranny.
The implication for this preface is that relevance in
economics depends on its being integrally tied up with
the fundamentals of institutional history. The heart
of this subject, again, from the economic standpoint, is
the relation between the r6les of conscious and un-
conscious, and rational and emotional factors, in
continuity and change. A little reflection on these lines
should make it less easy on the one hand to teach
"naive economism" and on the other hand to assume,
practically in the same sentence, as American "Institu-
tionalists" rather habitually do: (a) that it is all a
matter of historical forces, and (b) that it is all going to
be made over in short order, by the essayist or orator,
from his typewriter or speaker's stand. In this connec-
tion, it seems to me that a peculiar importance attaches
to language as the basic institution, and basic "tool,"


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PREFACE TO THE RE-ISSUE


at once of rational and emotional communication,
which are the stuff of social and all human life. Not
much linguistics can be included in the general training
of economists, but students might be reminded of the
main facts. The controversy between the historical
and analytical views of law, might well, however,
receive rather detailed emphasis in any economics
study programme. Beyond that, the need is for some
grasp of the infinitely complex, intangible and down-
right contradictory character of men's interests, con-
scious and unconscious, and their interaction with
equally intricate mechanical, biological, neural and
mental processes in forming the pattern of behaviour.
The great vice is over-simplification, and the leadership
which gets attention is as much addicted to it as the
inarticulate public. As between such conceptions as
universal love, will-to-power, and economic interest, the
only question is whether any one can be more absurd
than another as a theory or as an ideal of social
life.
Most pertinent for economists is the admonition to
achieve some defensible perspective in their view of
the r6le of intelligence, not forgetting the relation
between their own and other people's. Most of us are
still hypnotized by Enlightenment ideas, both of its
nature and of its importance, and this situation has
much to answer for in the current reaction toward anti-
intellectualism. There is an intellectual element in the
social problem. It is of two-fold nature, improvement in
technology, and correct allocation of resources, the
second being the economist's field. In any social
order, and whoever makes the decisions affecting
consumption and production, there is a difference
between economy and waste, to which it is stupid to be
indifferent, and the principles of what is (not too
happily) called "marginalism" are those of intelligent


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XXX PREFACE TO THE RE-ISSUE
policy. But these tell nothing as to content, as to what
concretely should be done.
Moreover, in a deeper sense, it is doubtful how far it is
possible to speak either of intelligent political policy
or of political intelligence. It is a late date to be
getting rid of the notion that intelligence provides any
solution for social problems. The existence of science
itself requires a scientific attitude, which is a moral-
aesthetic attitude, opposed to charlatanism and plain
faking (which are difficult in the face of experimental
tests, and easy in social science where such tests are
inapplicable). Even under "given conditions," broadly
interpreted, there are few social interests entirely
unaffected by conflicts of interest within society, and
no "intelligence" can tell anyone where or how far to
pursue a special interest against that which is more
general. But the great bulk of social problems have to
do with the "given conditions," the constitution and
laws of which make society society, which fix the
terms of co-operation and of competition, and of
association which is not primarily either. (And all
three types are inseparably mingled in any problem
situation.)
We "intellectuals" may condemn the crowd-mind for
unintelligent conceptions of economy, but we should
recognize that the more vital problems are not problems
of economy, but of maintaining social unity in the face
of economic interests. And the foundations of unity lie
not in intelligence, but in habit, emotion, and ideals of
value. Intelligence, as suggested before, is a very
ambiguous notion. In social relations we may admit
that intelligence enables the individual to play the
game more effectively, though even then it is intelligence
of a very different sort than that which proves mathe-
matical theorems or invents machines. And equally,
intelligence may enable the player to cheat more








PREFACE TO THE RE-ISSUE XXXi
effectively, or convert the game into a fight. The
social problem is preserve respect for the rules, and to
make such rules as result in the best game for all,
players and spectators. This is a moral problem, and
no reasonable stretching of the word intellectual will
bring it under that category. Indeed, if intelligence is
to be taken in the instrumentalist sense of power (to get
what one wants) now philosophically fashionable
(particularly in America, but it is the essence of the
whole utilitarian tradition, of which price-theory
economics was an integral part) then it is definitely and
dearly anti-social in tendency. If it is not counter-
balanced by moral forces, the development of such
intelligence must disrupt society. For, while the
individual may have everything to gain by preserving
society in some form, and may recognize the fact,
this will not and does not lead to agreement on any
particular form. Historically, political unity on any
considerable scale has originated rather in conquest
by force, and been maintained by habit, assisted. by
fear and hostility toward other social groups, and by
religion and morality in which the need for unity
against external foes plays a dominant r6le. Truly,
the social problem is more difficult than it was con-
ceived to be in the Age of the Enlightenment now
apparently coming finally to a close, and is of a
considerably different character.
As to the part to be played by anything like a
scientific economics in helping to solve the social
problem, I do not pretend to have any clear or simple
formula. Negatively, one thing is beyond dispute; it
cannot be at all that of a natural science, unless
government is to be an absolutism in an absolute sense
never yet seen, and the economist an adviser to such a
government, the first prescription regarding his work
being that it must never directly reach the public "on"








PREFACE TO THE REIISSUE


whom policies are to be carried out. Regarding any
published work, two things would appear requisite.
The first is that the writer have the utmost clarity
regarding his r6le and what is involved when a member
of society sets himself up in the position of thinking
for society. This includes (secondly) equal clarity
regarding the process of group thinking in its relation
to group action. All of these questions are the opposite
of easy (and consciousness of the difficulties will not
tend to make one's work a literary best-seller). Even
the most general considerations, which should be
axiomatic, are actually disputed. In any exposition
pretending to relevance it is, of course, assumed that
thought and expression are more than mechanical
process-yet men recognized as scholars and scientists
profess "behaviorism."
In addition, group thinking or discussion involves
something on a still higher-and intellectually more
unsatisfactory-level. Discussion must be something
other than (a) assertion of a preference-"I want it
so"; or (b) sales-talk in the interest of such a preference;
or (c) "talk" as itself a mere commodity, produced to
sell competitively. (There is no objection to any of
these, but they are not discussion, aspiring to relevance.)
Discussion must be problem-solving, hence must
assume that there are problems and right solutions, or
at least better and worse solutions. These solutions
can be of the nature of "truth" or of "right"-aesthetic
or moral; but truth is a form of right and right a form
of truth, and yet there is a contradiction for our minds
between the assumptions underlying the two lines of
interest and endeavour. Understanding of any material
implies at least a theoretical possibility of manipulation
and control, which presupposes determinism in the mat-
erial itself, and a position of the subject who understands
outside of the material, in a relation of understanding


xxxii








PREFACE TO THE RE-ISSUE


and control over it, but without being understood
and/or controlled by it. Now any discussion of
any problem-scientific problems are also social-
which is not self-stultified from the outset, must be
addressed by one such more or less self-determining
subject or mind to another or others. We have no
systematic logic for this relationship, which is merely to
say, no answer at all satisfactory to the primal dilemma
of thinking: that man seems to be at once a part of
nature, made what he is, and controlled by nature;
and outside of nature, in the relation of maker, or re-
maker, and controller over nature. No thinking, about
either nature or man, can make sense unless the second
relation is accepted as real. So the thinker about
society, if he adopts a natural-science position, must
assume that society is timelessly determined by its own
nature, which can only be changed from the outside,
by a "miracle." But to have relevance to social action,
he must assume both that society can choose to change
itself and that he can participate in initiating the choice
and can influence its character-or else he must
assume that he is outside of society and can change it.
But in the second case, his discourse is an attempt to
control, not a discussion. Parallel to the man-nature
dilemma, we face a similar paradox that the individual
is at once a part of and outside of society.
The crux of the whole matter lies, I think, in the
concept of discussion. As a plain matter of fact, we do
not discuss problems with natural objects, and we do,
or may, with human beings. But discussion must be
contrasted with persuasion, with any attempt to
influence directly the acts, or beliefs, or sentiments, of
others. Discussion is a co-operative quest of an im-
personally, "objectively" right (or best) solution of an
impersonal problem. It cannot be an attempt to
"sell" a solution already reached, or it is not discussion.


XXxill








PREFACE TO THE RE-ISSUE


This, I would say, is the basic error, or heresy, of
modern civilization, and represents a kind of original
sin. The spirit of discussion is the essence of the
scientific spirit, but the antithesis of the scientific
method. The utilitarian-pragmatic philosophy in-
volves the fatal confusion of carrying the scientific
method, rather than the spirit, into social relations.
The result is inevitably conflict, and finally chaos or
tyranny, rather than agreement and unity on a basis of
mutuality. For the instrumentalist-scientific attitude,
generalized, becomes mutual utilization, mutual ex-
ploitation, which is a logical impossibility.
But again, utilization of other human beings is not
primarily economic utilization, for no distinctively
human interest is at bottom economic. They all centre,
as a matter of social-psychological fact, in a wish to be
a person of some kind in a society of some kind. The
real question is whether it is to be "my" kind of person
and society or an ideal kind, acceptable to all. The
second alternative does not, however, eliminate the
competitive interest, provided that the interest in
winning is effectively subordinated to the interest in
having the best possible game for all alike. But the
"Adam" in man pulls in the other direction.
There is no better or more crucial illustration than
the situation of the economist. The positive pre-
requisite of a useful or true economics is merely that
it be aimed singly and whole-heartedly at finding and
exhibiting the universally useful and true (or nearest
possible approach to such an ideal) rather than at
personal aggrandizement in any sense. To this end, it
must be above reproach as to any desire to persuade,
to exert power, for any purpose. Radical critics of
economics accuse its expositors of being propagandists
for a class interest. That the authority of economics
has been claimed for what would now be classed as


xxxiv








PREFACE TO THE RE-ISSUE


propaganda for special interests is, of course, true. The
"class" interest detail probably has a little validity in
Europe, where feudal traditions survive to some
extent; I do not think it has any at all in America,
where class means simply community of interest, and
there are literally more such classes than there are
individuals. But the "economic" character of effective
communities of interest is, in any case, chiefly accidental
and superficial. It is paradoxical but true that men are
less likely to quarrel over food when it is really scarce
than when it is abundant enough to represent other
values rather than literal nourishment. Of course,
control over visible and tangible objects will always be
a mode of, and element in personal and group aggrand-
izement. But it is not in any distinctive sense economic
and is not the interest against which economists have
needed to be on guard in an age which attached
religious value to both science and liberty.
It seems to me probable that the first historical age
of humanitarian liberalism is passing, that Western
civilization will in the near future largely go over to a
sort of mediaevalism, but with a political orthodoxy
and priesthood in the place of the religious in setting
the criteria of thought and action. Free discussion,
in the form which it has actually taken, has in fact been
experimentally proven a failure. It leads through chaos
to tyranny, or to tyranny as the alternative to chaos.
People cannot be encouraged, or allowed, to think
independently unless they can and will think more
or less impartially and correctly, and in that sense, by
that path, think alike. The failure, however, I wish
to argue, lay in the fact that social "discussion" was
false to the ideal of discussion, was not discussion, but
debate, a contest for personal aggrandizement. (There
were material prizes, but that is not the essence of the
matter.) Social "science" and economics have not at


XXXV








xxxvi PREFACE TO THE RE-ISSUE
all withstood the general movement, the natural
implications of utilitarianism, scientificism, instrument-
alism. The best we can hope is that a few people will
learn the lesson and carry it forward to another
historical juncture, when the "other man," who is,
after all, likewise in humanity, the lover of truth and
right, and of mutuality and real co-operation, may
get another chance.
FRANK H. KNIGHT.


Chicago, August 1933.












PREFACE FOR THE REPRINT OF 1948
On the occasion of still another impression of this work,
the Editors have kindly invited "further remarks" from
the author, an invitation which I am glad to accept.
Gratification at the continued call for the book is mixed
with some misgivings as to whether it now deserves
study-assuming that it ever did-or has perhaps
rendered whatever service it was suited to perform and
might well be allowed quietly to give place to later
writings. Certainly, it is out of date in several respects,
in relation to the general movement of history, the
advance (or at least the movement) of economic science,
and even the development of the author's thinking.
The situation at the present date is not covered by the
Preface written for the first London reprint of 1933.
Much historical water has flowed by in these fifteen
years, and turbid water it has been, for the most part.
Moreover, that Preface was written under pressure by
a tired university teacher at the end of his school year,
fretting to get away on vacation. It now reads to me,
in parts, like an unfinished draft, and the content too
clearly reflects the writer's preoccupations of the hour.
But there is small satisfaction in noting how little the
course of events has done to confute the forebodings
which, as a liberal, I felt in August, 1933. The fifth
London impression of 1940 contained an "Additional
Note" relating more directly to points in the theoretical
treatment, and this I now wish to revise and amplify.1
Taking the theory of consumption and that of pro-
duction, including capital production, as two main
headings under which the bulk of analytical economics
1 This new Preface is a revision of one written two years ago for a
Spanish translation. This has finally been brought out, inthe present
year: M. Aguilar, Madrid.








xxxviii PREFACE FOR TUE REPRINT OF 1948
may be organised (distribution theory is not more
than a footnote), the bearings of risk and uncertainty
affect primarily the latter branch. In this connection
especially, I would address a few observations to
new readers at this time. They centre around the
theory of capital, which through the years I have
increasingly felt to be the hub and the pons asinormum
of general economic analysis. The text develops
the theory of "risk, uncertainty and profit"' from
the standpoint of a commonsense view of production,
according to which the "entrepreneur" buys productive
services at a given time, and converts them into
a product which he sells at a subsequent time. This
view suggests a kind of "period of production", though
it is not committed to the theory found in germ in
Ricardo and developed and popularised by Bohm-
Bawerk. By the early 1930's I had become convinced
that this view of production and of capital is fallacious,
and began to publish articles arguing the point. I also
recognized that the change of view called for a re-
statement of my theory of risk and uncertainty. (See
Economic Journalfor 1935, especially footnote, pp. 79-80.)
It now seems evident that profit must be computed
with respect to some dated interval of time, an account-
ing period, long or short. The profit of an enterprise or
other unit is the difference between actual receipts and
disbursements (including valid book charges and
credits) during such a period, increased or decreased
by any change in the aggregate value of its assets in the
same period. (Ideally, at this stage, a money unit of
constant value must be assumed.) The accounting
period may be taken as short as one pleases, down to a
point in time as a mathematical limit (reducing actual
changes to momentary rates of change).
It follows at once that the crucial matter for the
theory of uncertainty and profit is asset values and








PREFACE FOR THE REPRINT OF 1948 xxxix
their changes. This involves the theory of capital and
its rate of yield but distinguished from interest since
these values are derived by capitalising a future income
flow. The size and duration of the expected yield and
the rate at which it is to be capitalised are all more or
less uncertain, but all these data find logical expression
in the assets appearing on the books as closed and
balanced to show the state of affairs at a particular
moment. Ordinarily, the values embody anticipations
extending beyond any assignable limit in future time;
and strictly speaking, the case would be otherwise only
if the management acted in contemplation of a universal
liquidation (the "end of the world") at a fixed date.
(All actual liquidations involve transfers of some assets
to other accounts.)
It follows also that there is no period of production
or time interval separating production and consump-
tion. If the two are equal for any interval (the common
meaning of a "stationary economy") they are also
strictly simultaneous; all maintenance and replacement
of "agents" of any kind is a part of the production of
the services which alone are consumed. Consumption
may exceed production, the difference representing
disinvestment, decrease or "consumption" of capital.
The main source of confusion arises from the converse
fact, typical for modern industrial civilisation, that
production exceeds consumption, the difference repre-
senting investment or production of capital; this must
always mean net production, in excess fall maintenance,
including replacement, and regardless ofchange in form.
On a superficial view it was perhaps natural to think that
the production of capital goods and their subsequent use
to produce income is indirect production of future
goods, and that the amount of capital will correspond
with the degree of indirectness or the interval between
production and consumption. But a very little critical








xl PREFACE FOR THE REPRINT OF 1948
examination should make it clear that this view is un-
tenable. In a stationary or progressive economy, invest-
ment is in fact permanent, and in reality most single
items are committed with a presumption of perman-
ence, or even of reinvesting part of the yield-unless
and until some eventuality should call for realisation
by the owner; and this would not mean real net
liquidation from the standpoint of the economy as a
whole. Moreover, in the planned liquidation of any
increment of capital there is no concrete correspon-
dence, unit for unit or on the whole, with any previous
investment. Production of capital cannot be treated as
indirect production of its future yield; two productive
operations must be recognized, even though this seems
to involve double counting. The result of production,
either in consumed service or growth of capital, is
then always strictly simultaneous with production
itself, from instant to instant.
Another consequence is that in a logical classification
all useful agents of every kind must be included in
capital, and the notion of "primary" factors given up.
The plain fact is that all economic values in the world
have been produced in the past, in the economic sense,
and at equal cost for equal values except for errors in
foresight or calculation. Even human beings are only
in limited degree an exception. In a slave society this
would be evident and would raise no difficulty. In a
free society, problems arise which have no neat solution;
human beings are not bought and sold, investment in
them is not made under a close approximation to
economic conditions and, most important of all, the
maintenance of a "worker" cannot be distinguished at
all definitely from his consumption that is an end in
itself. But it is clear that human beings, and especially
their productive capacities, are produced, maintained
and replaced at an economic cost, and hence are in








PREFACE FOR THE REPRINT OF 1948 xli
essential respects like capital goods of the recognized
types. With respect to "natural agents" also, the present
value can be traced back to productive activity (in-
vestment) in exploration, development and the like,
including "waiting", the sacrifice of a return that might
have been secured for the human and other resources
used, along with taxes paid and other costs. This is true
of all types of agents as classes. It is not true of particu-
lar items, because of errors in foresight, or the emotional
attitude, positive or negative, towards adventure. These
must be assumed to balance in the long run, in so far
as they represent error in the strict sense and not a
"bias" of some sort, which would require imputation
of value, positive or negative.
Dropping the untenable conceptions of ultimate
resources, of capital goods as intermediate products,
and of a period of production, the correct picture of
production is not that of a "circular flow" (Kreislauf)
but that of an inclusive organic complex of agents,
human and non-human, which continuously maintains
itself and yields in addition a return available for con-
sumption or further investment. Measured in terms of
value, the only possible denominator, this is capital. Its
quantity depends on its anticipated net yield (which
depends on all the conditions prevailing in the economy)
and on the rate of capitalisation. The principles in-
volved would be the same for a Crusoe or in a society
organised in any way whatever. The "natural'.' or
equilibrium rate is the quotient of unity divided by the
cost, in sacrificed consumption, of creating new re-
sources of any kind that will yield a perpetual net
return of one unit per annum. New investment is made,
put into, not only "capital-goods" (in the sense of
goods in process, machines, etc.), natural agents and
human beings, but also technology and scientific
research, and social monuments and works of art; and








xlii PREFACE FOR THE REPRINT OF 1948
the costs, or the investment itself, include the services
of all those agents. In a pecuniary society the rate of
return, so determined and defined, also fixes the
"natural" rate of interest on loans. It should be noted
that all yields and the form of value of all agents depend
on the immaterial aspects of a culture or civilisation,
and that practically everything that is human, except
the anatomy and physiology of biological man (and
some even of that) is like capital, a cumulative historical
creation.

The feature of the present book which will now
strike readers as its most glaring defect is the virtual
absence of treatment of "the business cycle", and kin-
dred problems, which world experience since 1929 has
forced on the attention of economists and the public
as the major single source of uncertainty and profit-
or especially of loss-in business life. This topic also
belongs to the theory of production. With respect to the
scope of any single book (particularly a doctoral thesis
which this one originally was-Cornell University,
1916) the writer still holds it quite legitimate scientifi-
cally to adopt any limited set of assumptions. It is
doubtless a valid criticism of the classical-neoclassical
movement as a whole that it was so slow and tardy in
facing this set of problems and finding a place for the
phenomena in the corpus of its thinking. Because of a
combination of lack of the appropriate special know-
ledge and training, and a feeling that the balance of
effort was shifting too far in that direction away from
aspects of economics equally important and in need of
cultivation, the writer has stayed on the fringe of the
controversies centring around the problem of economic
stabilisation and full employment that have so largely
pre-empted the attention of economists since the
collapse which ushered in the Great Depression.








PREFACE FOR THE REPRINT OF 1948


Of course the topic was not entirely new at this date
(the early 30's), or even when my thesis-topic was
chosen in 1915. The gap in classical economic theory
was being filled in, by writers in various countries, but
especially in the United States after the panic of 190o7
-often in conjunction with unjustified attacks on theory
based on perfect markets and "neutral" money, with
the implication of full employment of all resources. But
a new era began under the Depression, and specifically
with the publication of Keynes' General Theory in 1935.
In the present context only a few brief observations can
be offered on this latest phase of events (prior to World
War II). With regard to most of this development, this
newest "newer economics", I have remained negative.
This applies especially to the "monetary" theory of
interest, but also to the whole project of making mone-
tary theory the centre and starting point of systematic
economics (with full employment as a "special case"),
and in large part specifically to the Keynesian theory
of money. It is in this last connection that some advance
is to be hoped for from Keynes' work, but I think it
will consist in provoking discussion of the tremendously
important role of monetary phenomena as causes of
disturbance and disequilibrium rather than in the
solutions proposed for the concrete problems. With
respect to the issues in the theory of boom and depres-
sion and unemployment, I am sure that analysis should
start from the fact that any speculative market typically
exhibits unstable equilibrium and a tendency for price
to oscillate within an indefinitely limited range.
Accordingly, cycles should be expected in connection
with all production subject to speculation, meaning all
goods that are durable and specialised, individually
and collectively. The special problem of "the" cycle is
that of expansion and contraction in the economy as
a whole, in contrast with particular lines, where


xliii








xliv PREFACE FOR THE REPRINT OF 1948
differences in phase and amplitude might be expected
to result in cancelling out.
The solution, I believe, is to be found in the applica-
tion of the same principles in the general market for
durable goods in terms of money, i.e., speculation in the
future value of money, in contrast with relative values
of different goods. This sort of speculation is largely
unconscious, but for that reason tends to be more
important in its effects. The corner-stone of any sound
theory of money and of the general business cycle
would be a clear distinction between the two main
functions of "real" money (apart from a unit of value)
namely, as a medium of payment establishing coinci-
dence of barter, and as a "store of value" or form for
holding wealth. In the former function, payments are
primarily for services, including wealth as stored-up
and anticipated services, and the velocity of circulation
of money, being a function of the established "institu-
tional" system of payments, is relatively stable. But in
the use of money as a store of wealth, in comparison
with real goods and with obligations stated in money,
the natural expectation must be cyclical oscillation of
circulation velocity and of prices, the quantity of money
being assumed constant. Whenever prices seem to be
rising or about to rise, all who hold this to be the case
will act in a way to make them rise, by converting
money into goods, through purchase and construction
-and conversely. In this case there are no tolerably
definite and known conditions of equilibrium to guide
speculation and restrict the range of oscillation, in
contrast with the world trade in a commodity like
wheat (but in spite of which its price shows fairly wide
movements). The speculative uncertainty and conse-
quent range of variation in general prices are corres-
pondingly large, partly because the fundamental con-
ditions affecting money and prices include the acts of








PREFACE FOR THE REPRINT OF I948 xlv
banking systems and governments over the world, as
well as the "real" factors of supply and demand for
goods. In consequence, men rather typically plan
general business policy in terms of current business
sentiment-what they think others are thinking and
planning-insteadofattempting to calculate what prices
ought to be, in view of the conditions which finally
determine them.
My chief ground for disagreement with the Keyne-
sian theory of money is the belief that in view of these
facts-some, or most, or all of them well recognized by
Keynes as well as others-supply and demand curves
for "liquidity" have no solid foundation and are not a
sound basis for action but are "theoretical" in the bad
and misleading sense. I feel that Pigou has a sounder
approach to the fundamental problem, pointing to
maintaining price stability by stabilising "confidence",
or counteracting the tendency of business psychology
to run from depression to boom and to generate the
inevitable reaction. With respect to policy in a depres-
sion, the concept of the "multiplier" rests on inverted
logic; the aim should be to bring about dishoarding
rather than a calculated direct inflation. The view that
all saving is hoarding is even more fallacious than a
naive acceptance of Say's Law. And the idea of a
menace from general oversaving is quite indefensible;
if men want to save and hoard, an effective monetary
policy would make them benefactors of society prac-
tically to the extent of their excess of production over
consumption, since the cost of supplying the extra cash
should be negligible. In political terms, the problem of
stabilisation is to accomplish the result under a govern-
ment of law, for, apart from political objections, too
much discretion in the hands of administrators will
defeat the end of confidence.
*








xlvi PREFACE FOR THE REPRINT OF 1948
With respect to the theory of consumption, the other
main branch of formal economic analysis, what I would
say in advance to new readers must be indicated briefly.
This is partly because the subject admits of no very
definitive treatment and a tolerably adequate dis-
cussion would run to undue length. The theory of
"diminishing utility" happened to become involved in
a new wave of controversy at about the same time as
the publication of Keynes' General Theory. It was
initiated by Hicks and Allen and Henry Schultz, who
independently rediscovered the work of E. Slutsky, and
was taken up and propagated chiefly by mathematical
expositors. In the book here presented, I dealt rather
disparagingly with the utility principle in the main
discussion (Ch. III) and believe I somewhere referred
to it as "pernicious" doctrine. Further reflection, in
connection with class-room discussion and critical con-
sideration of the new literature attacking the theory,
has convinced me that utility theory in something like
the traditional form-but completely divorced from
hedonism-is sound and necessary for general economic
analysis, but care must be used in stating it and in
drawing and interpreting curves. The indifference
curve of Edgeworth and Pareto is equivalent to a
relative-utility curve, but has advantages for some
purposes. All plane curves have severe limitations for
representing a system with more than two commodities,
and this is particularly true of the demand curve for a
single good in terms of money. It is impossible to assume
all "other things equal"; in particular a choice must be
made between assuming the constancy of all other
prices and of the individual's real income. Contrary to
the tendency in recent writing, I favour the latter
alternative, because it effects a sharp separation of the
problem of money from that of relative prices.
*








PREFACE FOR THE REPRINT OF 1948


My last note will have to do with the relevance of
economic principles, in view of the current trends in
history and drift of economic and political thinking.
The type of economics represented in this book grew up
in the atmosphere of the social and political philosophy
of the Enlightenment, described by the terms, rational-
ism and individualism, and characterized by the ideals
of freedom and equality. In the social structure that
spread widely through the world in the nineteenth
century-in the first instance from Britain, then with
a powerful impulse from Britain's North American
colonies, the United States of America, and France-
these ideas found a dual embodiment: political, in
popular government through elected and responsible
representatives; economic, in the free market and free
enterprise. Both the political and the economic aspects
of individualism have been under fire for a long time,
and definitely on the defensive, with the latter especi-
ally in retreat, in recent decades. Free enterprise was
attacked even in England by near contemporaries of
Ricardo, and full-grown revolutionary socialism may
be dated from the publication of the Communist
Manifesto in the same year as J. S. Mill's Political
Economy, 1848. The triumph of Marxism in Russia in
World War I was followed by the surrender of parlia-
mentary regimes to anticommunist parties in Italy and
Germany and similar changes elsewhere; and equally
symptomatic is the growth of economic stateism of
divers forms in Britain and America, marked by the
accession to power of a socialistic party in the former.
Without embarking here on any discussion of the vast
issues raised by this broad sweep of change, I wish to
record a few comments which are pertinent to the
interpretation of the present book.
First, I must stress the fallacy of the view so commonly
expressed with respect to the classical or price-mechanics


xlvii








xlviii PREFACE FOR THE REPRINT OF 1948
type of economics, that it is descriptively or practically
relevant only to societies economically organised on
the pattern of modern capitalism or free enterprise.
This erroneous view is suggested and enforced by the
historical fact of temporal coincidence of develop-
ment, and for many details of the analysis it is true.
But with respect to fundamentals, it is false, for two
reasons. In the first place, no socialistic or authoritarian
movement tries or seriously proposes to do away with
the purchase and sale of goods and services for money,
in markets (more or less free), as the main feature of
economic organisation in the concrete. This would not
be possible without reverting from civilisation in the
modern sense back to a primitive mode of life; for, the
allocation of resources, technical conduct of production
and rationing of product would present an insuperable
administrative problem, even if all concern for indi-
vidual liberty were thrown into discard. (It should not
need to be argued that the open market for goods and
services is the only mechanism that can provide for
large-scale co-operation for mutual advantage along
with freedom of choice to both consumers and pro-
ducers.) But in the second place, the more general
principles of analytic economics are simply the prin-
ciples of economic behaviour, of the effective achieve-
ment of ends by use of means, by individuals and
groups, irrespective of social and political forms. Even
under a "pharoah", combining absolute sovereignty
with outright ownership of men themselves as well as
the land and goods, much the same choices and
decisions would have to be made to make activity
effective rather than wasteful and futile; and the
abstract principles of economy and of organisation are
the same regardless of who makes the choices, or what
means and techniques are employed, or what ends are
pursued.








PREFACE FOR THE REPRINT OF 1948


Secondly, as a last word, I may offer a brief declara-
tion of social-ethical faith, or ideological position. Of
course I do not believe in literal "laisser-faire"; I know
of no reputable economist who ever did. Certainly
neither Smith and Ricardo nor Cobden and Bright
would have restricted the state entirely to the negative
functions of policing individual liberty and defense
against outside attack. No one denies that "man is a
social animal"; and in fact society makes men far more
than men make society, meaning by deliberate thinking
and action. Yet I believe that individualism must be
the political philosophy of intelligent and morally
serious men. The choice lies between allowing people
to fix the general form and terms of association by
mutual consent, and having all conduct ordered by
some authority, ultimately one based on a claim to a
prescriptive right to power. Both reasoning and his-
torical experience seem to show that in spite of the
crudities of free society, and the undoubted fact that a
majority may be a tyrant of the worst sort, authori-
tarian control is worse. It is both expedient and funda-
mentally right for the normal human adult to be
responsible for himself, to "make his own mistakes",
and to carry his share of responsibility for the com-
munity. Accordingly, it seems demonstrable that both
representative political institutions and free exchange
and free enterprise are essential to the general frame-
work of a truly moral social order.
All this rests on ethical judgment, or predilection,
and is subject to disagreement by those who believe
either in some particular ideology, or in the feasibility
of a democratic collectivism that will preserve the basic
liberties and responsibilities of the individual. Britain
and America, and perhaps some other countries, seem
to be headed for trial of sweeping control and participa-
tion by the state in economic life, ostensibly in the


xlix








1 PREFACE FOR THE REPRINT OF 1948
interest of the original Enlightenment ideals of liberty
and equality, political and economic. The issue here is
also arguable; in fact, the theory is attractive in the
abstract, until one goes into some detail in the light of
political reality and historical experience. But it is my
conviction that any great extension of state action in
economics is incompatible with political liberty, that
"control" will call for more control and tend to run
into complete regimentation-calling also, before it
goes very far, for regimentation of thought and expres-
sion-and finally into absolutism, with or without a
destructive struggle for power. Moreover, aggrandise-
ment of the state must be at the expense of the family
and all voluntary and institutional groups, and must
intensify relations of conflict between states, where the
greatest threat of universal catastrophe already looms.
On the other side, there is an undeniable natural
tendency toward increasing inequality and concen-
tration of power under free enterprise itself, which
political action seems the only way of counteracting.
The vast material and intellectual progress under the
short era of liberalism threatens to be its own undoing,
through placing power-physical, intellectual, organi-
sational, and moral or psychological-in the hands of
man and especially the common man, more rapidly
than he has educated himself to distribute it equitably
and use it wisely. For the visible future, the problems
of modern civilisation are to be solved only through
striving for the best possible compromise among con-
flicting goods and associated evils. Responsible citizen-
ship calls for a rather terrifying amount and range of
intellectual and moral equipment. Such books as this
may hope to make a contribution in one modest but
essential sector, the understanding of the mechanism
of the open market as a method of co-operation. For
this type of organisation must surely have a large role








PREFACE FOR THE REPRINT OF 1948 li
as long as men are men and neither bees in a hive nor
pieces in a game where a few magnates struggle for
power.
FRANK H. KNIGHT.
Chicago, U.S.A.
October 1948.












PREFACE FOR THE REPRINT OF 1957
IT is gratifying to learn that another printing of this
book is thought justified, and to be invited to add a new
Preface to those of 1933 and 1948 (the latter incor-
porating an "Additional Note" of 1940). What to say,
within allowable compass, is a problem. First of all, I
would urge any reader to consider these prefaces, as
well as the fact that the book was a Jugendarbeit;
originally, it was a "masterpiece" in the old sense, by
which an apprentice qualified for admission to the gild.
Viewed at this time, it is an introduction to the prefaces
almost as much as the converse is the case.
The occasion suggests a few notes on the drift of the
writer's thinking in later years. This has centered on
the problem of making academic economics more
useful to society. Hence it has tended to stress funda-
mentals and simplifying their statement in common-
sense terms, along with their limitations in comparison
with the complexity of real problems, rather than
refinement of theory as such. Thus the direction taken
has not been that most prominent in the professional
journals-statistical model-building and mathematical
analysis. Examples may be found in two bound collec-
tions of articles: Freedom and Reform (Harper & Bros.,
1947) and Papers on the History and Method of Economics
(Univ. of Chicago Press, 1956). To these may be added
a lecture-"Science and Society: The Modes of Law," in
The State of the Social Sciences (L. D. White, Ed.; Univ.
of Chicago Press, 1956). In the field of theory itself, I
may list two articles on basic issues in the Journal of
Political Economy Vol. LII (1944): "Diminishing Re-
turns from Investment," and "Realism and Relevance
in the Theory of Demand."
Reflection along the line first mentioned has tended
to emphasize three facts: First: what economics has to
teach society that is most important for policy consists








PREFACE FOR THE REPRINT OF 1957 llm
chiefly of truisms, and applications which are also at
the level of the obvious. For positive action-not for
avoiding stupid policies-these must be given quanti-
tative content, as far as feasible, through empirical
investigation; but the results can never approach in
accuracy or reliability the laws of physical science.
Secondly, the economist's conclusions go only a small
way toward complete analysis; and thirdly, obvious
and potentially useful as economic facts and principles
are, they are constantly flouted in political action-
even formally disputed or their relevance denied. The
most serious question is, why such is the case. What is
believed by the public or its appointed agents the poli-
ticians ("insidious and crafty animals," Adam Smith
called them) is what controls policy, regardless of what
is true or germane. Economists must face the task of
combatting "prejudice," in favor of an objective
attitude. Moreover, in a free society the principle of
consumer sovereignty applies in education; the public
is bound to get what it wants. Hence anyone can find
an "economist" to endorse nearly any doctrine or
policy likely to influence the election returns in a way
desired for any reason. So, we pursue policies like
protectionism (obstruction of useful specialization),
"easy money" (inflation) and arbitrary price-fixing
(legislating for shortage or surplus as the case may be).
The problems set by prejudice lie outside the field of
scientific economics, yet are vital for the task for which
economists as teachers and writers are presumably paid
salaries. They raise the unpleasant question of where
to compromise between expounding more truth and
being more useful. Economists need to understand the
mental and social forces which control opinion, and to
face the problem of "selling their line." They must
take account of the criticism of "theory" for assuming
"unrealistically" that men act rationally. One cannot
argue against prejudice and dogmatism, yet must resist
too much corruption of economic science by the eco-
nomics of demand and supply. They must recognize,








11V PREFACE FOR THE REPRINT OF 1957
too, that the abstractly rational economic principles
are in fact much "corrupted" in action by individu-
alistic and social interests-harmonious and conflicting
-which do not fit analytical curves and functions.
Especially important are the attitudes of work and
play, which are not traits of the "economic man" of
theory. He does not "compete"; but the emulative
motive corrupts much more the rationality of the
political man, who must make the application of
science. All this does not invalidate the economic laws,
or destroy their usefulness; but it enormously com-
plicates the interpretation and limits the application.
Thus there is important truth, of a sort and up to a
point, in the criticisms of analytical theory by the
historical schools and their continuators in the United
States, the "institutionalists." But it would be a great
improvement if controversy over "approaches" were
replaced by co-operation in the solving of problems,
finally involving all the sciences or disciplines that deal
in any way with conduct. However, division of labor
in this field is vastly more difficult than it is in natural
science and technology.
Price theory on the traditional lines (filled in with
empirical-quantitative content) is by far the most
scientific of the disciplines dealing with motivated
human behavior, and the most usable in guiding social
action. It expounds simple and indeed self-evident
laws governing the proportioning of goods and services
in consumption and of productive agents or their
services in production, and governing pricing in markets
and the organization of production and distribution
through price forces. The laws are valid, descriptively
and ideally, as far as the assumptions underlying free
society are valid; i.e., as far as men as they are can be
trusted to manage their own affairs (individually or in
voluntary association) comparably with any author-
itarian direction that can be expected. They enable a
society to predict, if it will, the course events will take
in the absence of action and the effects of acting in








PREFACE FOR THE REPRINT OF 1957 Iv
possible ways, both much more reliably than is the case
elsewhere; for example, in criminal jurisprudence or
especially in "politics." This trustworthiness of the
common man, depending on competence and the
elementary morality of respecting the freedom of
others, is valid only up to a point, which is different in
different social situations. That fact sets one part of the
problem of social-economic action-the policing of
freedom. It is a hard problem, yet on the whole a
minor one. Harder is provision for the defense of a
society against external enemies; that will be present
as long as "society" means primarily sovereign states,
hence for any foreseeable future. Connected with it
are issues in international economic relations, though
these are largely fictitious and would disappear if men
were more rational.
The major problems of economic policy (for a state,
taken as given) arise out of conflicting ideals of dis-
tributive justice-with the impossibility of approx-
imately realizing any of them, under the unchangeable
conditions of human life. The necessary compromises
are a matter of judgment, not of any formula. Liberal
social philosophy replaces the concept of justice as
defined by law, accepted as sacred, eternal and im-
mutable-including a divinely ordained authority for
its interpretation and enforcement-by ideals for
criticizing the laws and acting to make them more
"just." It also replaces justice in accord with inherited
social status, a class justice, with the ideal of justice
between individuals. But problems of individualistic
justice merge into matters of impossibility and necessity
-primarily because a society is only in part made up
of responsible individuals. The family is the minimum
real unit, in consumption and production-and also
laregly in politics. In our free civilization, human
beings are not born with, or born into a situation where
they automatically acquire, the capacities or equipment
needed for effective participation in such social life.
The crucial freedom is that of the family-procreation








Ivi PREFACE FOR THE REPRINT OF 1957
and the division of the responsibility for a fair start for
the offspring between the parents and the various units
of the political order. Then, the incapacity of adults
to take care of themselves at tolerable standards sets
further imperative tasks, beyond what voluntary
charity will do. Moreover, idealism cannot stop at
state frontiers, and the problem of international
relations or a world-order becomes vastly harder and
more pressing.
Economics, in a practical reference, must be "wel-
fare" economics, and that most pointedly calls for co-
operation between disciplines. It presents the two-fold
problem of social ends and means, but these often
mingle inseparably. It is absurd to say that there can
be no interpersonal comparison of "utilities" or needs.
All social problems arise out of conflicts of interests,
and every judgment touching on social policy involves
such comparisons. The beginning is in taxation, to
support the minimum activities of government, what-
ever they are held to be. Then, apart from policing
freedom and order, and promoting justice (really
"familistic") in distribution, there are numerous
functions which must be carried out by unitary action
of groups, defined by geographical area. Many
essential goods cannot be assigned to individuals.
Terms of participation must then be compulsory on all
who live in the area, and that means political action.
There must be agreement on policies in detail, hence
compulsion in so far as unanimity is not reached
"freely," through discussion with equal participation.
An intelligent believer in freedom will carefully com-
pare the inevitable sacrifice of that good with any gain
from group action-after making reasonably sure that
the gain will result.
Most problems of action are "economic" in that they
call for effective use of means, involving their allocation
among alternative modes of use (in such a way as to
"maximize" a total desirable result, by equalizing at
the margin). This obviously holds for "higher" goods








PREFACE FOR THE REPRINT OF 1957 Ivii
as well as for "lower." Social action is distinctive in
that (a) the uses to be compared yield goods for different
individuals (or for a group as a whole) and (b) the
means belong (in free society) to individuals with a
presumptive right to control their use. These facts
dictate a social (agreed) definition of a common end,
"welfare," defined as a balance among cognitive values
(traditionally classified as the true, the beautiful and the
good or right). The preferences which control indi-
vidual choices cannot function here. Assertion of
opposed interests cannot lead toward agreement but
must intensify antagonism and drive to hostility. The
content of welfare is a problem for ethics, or social
ethics, distinguished from "morals." The subject of
the latter is relations between persons in a given social
order, while "ethics," as used here, deals with the
improvement of both, i.e., with social progress. On
that, it is needless to stress the difficulty of securing
agreement.
On the other hand, the predictive side of the problem
is a matter of facts and descriptive laws, partly scientific
in a distinctive sense, partly historical. In both fields
intelligent action demands knowledge which only in a
limited part is possessed or to be had. A group needs
to understand causality in both forms to take the first
step, which is to separate what is unalterably given
from what can be changed by action. Historical
causality is particularly obscure, and such knowledge
is hard to interpret and use if obtained. Liberal society
itself is a mysterious product of very recent history.
After the Middle Ages, a vast cultural revolution
brought individual freedom, beginning with science
and intellectual inquiry, then in economics and politics
(free enterprise and democracy). The struggle became
serious only a few generations ago and has continued
virtually until now. The new outlook on life largely
reverses the principles of tradition and authority
underlying the study of men and law and government
in all previous time. The repetitive or constant factors








Iviii PREFACE FOR THE REPRINT OF 1957
in social change are the province of the various social
sciences. For economic policy that means primarily
economics and politics-the latter properly auxiliary
to jurisprudence. Underlying these, besides history
and anthropology, are psychology, sociology, and the
other "behavioral" sciences.
Back of history lies pre-history, and back of that the
biological evolution of man. For intelligent social
action a great deal of knowledge about that is needed,
which it seems can never be had. It would be especially
valuable to understand how instinctive social life was
replaced by "culture," transmitted by imitative in-
heritance. This would include the growth of language,
the basis of man's distinctive mentality, intellectual and
emotional. In contrast with the essential biological
unity of the species, produced by evolution, is the
boundless differentiation of cultures-language and
other usages, and men's value attitudes. Historically,
cultural determinism was infiltrated by authority-
church and state. In a free society, the mixture must be
replaced by mass intelligence. Fundamental to all else
is the problem of knowledge itself-what we can know,
and how, about social causation and values. The basic
fact is symbolic communication between minds. That
is the main direct source of knowledge of men by men,
and underlies all knowledge of nature, with which the
knower does not communicate and which does not
know or use him.
The "moral" of any objective critical survey of the
social policy problem is to be cautious or conservative
toward action. The possibility of acting intelligently
is very limited; and any other action will probably
have results more bad than good, if not disastrous. To
act intelligently men must curb their romantic pro-
pensity to jump to conclusions on desirable changes
and to "do something." Especially, they must learn
to respect the most solid knowledge there is, the simple
truisms of economics, while recognizing their limitations.
The theme of what is written so far is the limitations








PREFACE FOR THE REPRINT OF 1957 lix
of knowledge, compared with the requirement for
intelligent action. It is closely related to that of the
book here re-prefaced, the economic consequences of
"uncertainty." That argument starts with the ten-
dency of a theoretically ideal market economy (mis-
called perfectly competitive) toward an equilibrium
eliminating profit, i.e., "pure" profit, which is defined
by the principle stated. Completely rational and
informed behavior by everyone in a free economy
would make money costs equal to selling prices and
distribute the whole product among the productive
agents participating. Universal foreknowledge would
leave no place for an "entrepreneur." His role is to
improve knowledge, especially foresight, and bear the
incidence of its limitations. Thus an essay on the
theory of profit becomes an analysis of the price
economy, with especial reference to the entrepreneurial
function and income-positive or negative, profit or
loss. The word "uncertainty" seemed besf for dis-
tinguishing the defects of managerial knowledge from
the ordinary "risks" of business activity, which can
feasibly be reduced if not eliminated by applying the
insurance principle through some organization for
grouping cases. Thus uncertainty explains profit and
loss; but profit, when it occurs, is not properly a "re-
ward for risk-taking," though the expectation of gain
is the incentive for assuming the entrepreneurial role.
Nor is entrepreneurship to be treated as a "factor of
production" on a par with others, since it is not in at all
the same sense measurable or subject to varying pro-
portions and marginal imputation. Profit (when
positive) is not the price of the service of its recipient,
but a "residual," the one true residual in distribution.
One analytical defect in the treatment has been
mentioned-the "production-period" fallacy. When
the book was written, I did not see that every produc-
tive act must yield its value result instantly, either as
product ready for consumption (in the case of a service,
instantly consumed) or as an accretion to capital.








Ix PREFACE FOR THE REPRINT OF 1957
(Otherwise no production has occurred.) This is the
principal change that would be made if the book were
being written now. With that exception, the theory of
enterprise and profit would not be essentially changed.
In particular, no more elaborate theory of uncertainty
would be offered. That would require a treatise on
science and epistemology. It is still my conviction that
contingency or "chance" is an unanalyzable fact of
nature. This is now generally recognized, through the
progress of physics. Probability theory is merely the
mathematics of the distribution of "possibilities"
(another undefinable concept) in situations which
cannot be empirically identified. We can talk about,
for example, a "perfectly fair" gambling situation; but
none exists or can be created. Chance is more than
human ignorance of causality which is "really" ab-
solute; that idea was always a dogma, an intellectual
prejudice. No perfect probability class can be known
as such (atomic disintegration "may" be one) and every
knowledge or choice situation involves some element of
chance. Hence any grouping of cases will involve some
offsetting. Perfect randomness cannot be defined, or its
relation to "error" stated-nor to "freedom." For that,
contingency seems to be a prerequisite, but freedom
involves a mysterious something more, an act, in a
unique sense, of "will."
These relations raise questions which surely have no
definite answers and are in so far unreal. That is, any
answer leads to absurdity and will not be generally
accepted. (The romantic human craving for answers
where there are none will no doubt continue to produce
them a-plenty, and they will be advocated with a fervor
inversely related to their objective cogency.) The
difference between chance and ignorance of causation
is presumably "infinitesimal," like the difference
between free choice and chance or rigorous causality.
Both differences are surely small beyond any possibility
of empirical detection. The size of either difference is
immaterial, since familiar reactions can amplify the








PREFACE FOR THE REPRINT OF 1957 1xi
consequences of a discontinuous change without limit.
In exposition I should now strive for a somewhat
sharper analysis, stressing especially that there is no
connection between profit and the use of property.
The separation from wages, however, cannot be very
definite. I have elsewhere suggested the case of two
men ("workers") proposing to carry out a project
together, with no other "factors" involved. They
would have a choice: either to negotiate agreement in
advance on all details of what is to be done by each
and the sharing of the result; or, a much simpler
arrangement would be for one of them to take charge
and assure to the other a more or less definite return, his
own "share" (positive or negative) to depend on the
outcome. In a social ethos of free contract, the latter
seems to be the more natural recourse, unless there is a
"familial" relation between the parties. This hypo.
thetical case exemplifies all the theoretical essentials of
entrepreneurship and profit.
F. H. KNIGHT.
Chicago, November 1956.











CONTENTS
Preface to the First Edition .. .. .. .. vii
Preface to the Re-issue (1933) .... xi
Preface for the Reprint of 1948 .... xxxvii
Preface for the Reprint of 1957 .. lii

PART ONE
INTRODUCTORY
CHAPTER I. THE PLACE OF PROFIT AND UNCERTAINTY
IN ECONOMIC THEORY 3
The nature and necessity of a deductive science of economics -
Analogy of physical science Necessity of emphasizing the
abstract character of hypotheses Thought means analysis
and analysis abstraction The assumption of perfect com-
petition Profit absent The conditions of perfect competi-
tion include especially perfect knowledge, and profit is to be ex-
plained by uncertainty Plan of the book.

CHAPTER II. THEORIES OF PROFIT; CHANGE AND RISK
IN RELATION TO PROFIT 92
Historical sketch of the treatment of profit in economic litera-
ture Special consideration of the Dynamic and the Risk the-
ories The former confuses the effects of change with those of
the uncertainty connected with change The latter falls into
confusion by failing to distinguish between risk in the sense of
a measurable probability and an uncertainty which cannot be
measured Change according to a known law does not give rise
to profit, nor does risk if measurable, since it can be eliminated
by insurance or some equivalent device.

PART TWO
PERFECT COMPETITION
CHAPTER III. THE THEORY OF CHOICE AND OF EX-
CHANGE 51
Wants, and the economic order as a mechanism for organizing
want-satisfying activity Conflict of wants Resources, and
their use to satisfy a plurality of wants Utility and Dimin-
ishing Ut ility -Simple choices; the boy and the berries; Crusoe
and the Crusoe economy; the production and exchange of goods
under simplified social conditions The problem that of com-
bining alternatives Pleasure and pain relative Cost is
a sacrificed alternative The true significance of resources and
resource costs Formulation of the relations in functions,
curves and equilibria.










lxiv


CONTENTS


CHAPTER IV. JOINT PRODUCTION AND CAPITALIZATION 94
The use of a plurality of kinds of resource in producing various
commodities and the resulting problem of organization The
law of diminishing returns, analogue of the law of diminishing
utility The imputation of product-values to resources or
cost-goods and resultant placing of the latter to maximize their
yield Critique of the productivity theory The values of
productive services in terms of demand and supply No valid
classification of productive agencies into "factors" is possible
-The r61e of time in production and the fallacy of time-
preference.

CHAPTER V. CHANGE AND PROGRESS WITH UNCER-
TAINTY ABSENT 141
The meaning of static conditions and the forms of progress -
Question of classifying productive agencies along conventional
tripartite lines Changes in supply and demand of productive
goods and in the distributive shares Question of progress
toward equilibrium levels All modes of progress represent
alternative methods of investing present resources for a future
gain With uncertainty absent the rate of return would be
equal in all these fields Contrast with present facts The
nature of interest as.a peculiar form of income, distinguishable
from rent.
CHAPTER VI. MINOR PREREQUISITES FOR PERFECT
COMPETITION 174
Brief consideration of conditions requisite for perfect competi-
tion other than the absence of uncertainty Divisibility of
elements in the adjustment Lack of moral connotation of
the term "productivity" Monopoly; various forms; is pro-
ductive in the economic sense Tendency of a competitive
system toward monopoly and a universal dead-lock.

PART THREE

IMPERFECT COMPETITION THROUGH RISK AND
UNCERTAINTY
CHAPTER VII. THE MEANING OF RISK AND UNCER-
TAINTY 197
Outlines of a theory of knowledge The r61e of consciousness
in behavior Conduct is forward-looking and the problem of
knowledge is prediction Knowledge of the future depends on
the fact that experience can be analyzed into the behavior of oh-










CONTENTS


jects which maintain their identity But there are too many
of these for our intelligence to handle, so we depend on inferring
one mode of behavior from another; i.e., upon constancy in asso-
ciation of properties -Generally speaking, exhaustive and
quantitative analysis is impossible, and we "estimate" Com-
monly there is a diversity in the possible modes of behavior to
be inferred, and we reason in terms of "probability" of various
outcomes Probability a prior vs. statistical Errors in
judgment usually not susceptible to objective evaluation on
any ground, though they are estimated as probabilities The
"risks" which give rise to profit are chiefly of the nature of
chances of error in judgment, and hence not measurable, be-
cause too unique to form into classes.

CHAPTER VIII. STRUCTURES AND METHODS FOR
MEETING UNCERTAINTY 23S
Attitudes toward uncertainty Variable factors Free enter-
prise The economic organization deals with uncertainty by
reducing it or specializing the function of meeting it The
chief method of reduction is by consolidation, though impor-
tant structures exist for perfecting information and for the
direct control of the future Insurance the chief device for
consolidation- Speculation specializes risk, but is fully as
important as a means of consolidation Large-scale operation,
especially the corporation Promotion.

CHAPTER IX. ENTERPRISE AND PROFIT 264
Introduction of uncertainty into a perfectly equilibrated static
society Specialization of the function of management and
risk-assumption Contractual income and residual income -
Conditions which control the amount of the profit share, chiefly
timidity vs. optimism of entrepreneurs, especially in estimating
their own powers- Supply and demand of entrepreneur
ability.

CHAPTER X. ENTERPRISE AND PROFIT (continued)
THE SALARIED MANAGER 291
Indirectness of knowledge and control We generally judge the
capacity of some one else to judge for us and not our problem
itself In the same way we get things done by getting others
to do them The characteristic quality of the executive is
judgment of men The final control is the selection of men to
control in business organization, and this is inseparable from
responsibility The distribution of authority and responsibil-
ity in the modem business world.










lxvi CONTENTS

CHAPTER XI. UNCERTAINTY AND SOCIAL PROGRESS 813
Change, the main source of uncertainty, is the source of the
problem of control Uncertainty in the investment of re-
sources gives rise to a separation of the function of investment
from that of saving The theory of interest The uncer-
tainty element in relation to the various forms of progressive
change Complicated problems arising out of the capitaliza-
tion of profits -The permanence of profit; friction, and mo-
bility.

CHAPTER XII. SOCIAL ASPECTS OF UNCERTAINTY AND
PROFIT S47
All methods of reducing or redistributing uncertainty involve
costs The extent to which they should be carried depends
upon how far uncertainty as such is undesirable Free enter-
prise concentrates control and responsibility in the hands of
property-owners, and a small class of these Contrast between
free enterprise and freedom From the standpoint of efficiency
alone it is fairly clear that men work more interestedly and
effectively for an uncertain than for a certain reward Ques-
tion of the aggregate amount of the profit share All evidence
indicates that it is negative Question of abolishing free enter-
prise in favor of some other system Largely a problem of get-
ting those in control of economic activity to feel an independent
creative spirit The great difficulty of control beyond one's
own life-time; social continuity and the family problem.
INDEX 377


















RISK, UNCERTAINTY, AND PROFIT
PART I
INTRODUCTORY














RISK, UNCERTAINTY, AND PROFIT


CHAPTER I
THE PLACE OF PROFIT AND UNCERTAINTY IN
ECONOMIC THEORY

ECONOMICS, or more properly theoretical economics, is
the only one of the social sciences which has aspired to the
distinction of an exact science. To the extent that it is an
exact science it must accept the limitations as well as share
the dignity thereto pertaining, and it thus becomes like
physics or mathematics in being necessarily somewhat
abstract and unreal. In fact it is different from physics in
degree, since, though it cannot well be made so exact, yet
for special reasons it secures a moderate degree of exactness
only at the cost of much greater unreality. The very con-
ception of'an exact science involves abstraction; its ideal is
analytic treatment, and analysis and abstraction are vir-
tually synonyms. We have given us the task of reducing to
order a complex mass of interrelated changes, which is
to say, of analyzing them into uniformities of sequence or
behavior, called laws, and the isolation of the different
elementary sequences for separate study.
Sometimes the various elementary constituents of our
complex phenomenon are met with in nature in isolation
complete or partial, and sometimes artificial experiments
can be devised to present them either alone or with attend-
ant conditions subject to control. The latter is, of course,
the characteristic procedure of physical science. Its applica-
tion to the study of industrial society is, however, generally
impracticable. Here we must commonly search for man-








4 RISK, UNCERTAINTY, AND PROFIT
ifestations of the various factors in our complex, under
varying associations, or rely upon intuitive knowledge of
general principles and follow through the workings of in-
dividual chains of sequence by logical processes.
The application of the analytic method in any class of
problems is always very incomplete. It is never possible to
deal in this way with a very large proportion, numerically
speaking, of the vast complexity of factors entering into a
normal real situation such as we must cope with in practi-
cal life. The value of the method depends on the fact that
in large groups of problem situations certain elements are
common and are not merely present in each single case, but
in addition are both few in number and important enough
largely to dominate the situations. The laws of these few
elements, therefore, enable us to reach an approximation
to the law of the situation as a whole. They give us state-
ments of what "tends" to hold true or "would" hold
true under "ideal" conditions, meaning merely in a situa-
tion where the numerous and variable but less important
"other things" which our laws do not take into account
were entirely absent.
Thus, in physics, the model and archetype of an exact
science of nature, a relatively small and workable number
of laws or principles tell us what would happen if simplified
conditions be assumed and all disturbing factors elimi-
nated. The simplified conditions include specifications as
to dimensions, mass, shape, smoothness, rigidity, elasticity
and properties generally of the objects worked with,
specifications usually quite impossible to realize in fact,
yet absolutely necessary to make, while the "disturbing
factors" are simply anything not included in the specifica-
tions, and their actual elimination is probably equally
impossible to realize, and, again, equally necessary to
assume. Only thus could we ever obtain "laws," de-
scriptions of the separate elements of phenomena and their
separate behavior. And while such laws, of course, never









IN ECONOMIC THEORY


accurately hold good in any particular case, because they
are incomplete, not including all the elements in the case,
yet they enable us to deal with practical problems intelli-
gently because they are approximately true and we know
how to discount their incompleteness. Only by such ap-
proximations, reached by dealing analytically with the
more important and more universal aspects of phenom-
ena, could we ever have attained any intelligent concep-
tion of the behavior of masses of matter in motion and
secured our present marvelous mastery over the forces of
nature.
In a similar way, but for various reasons not so com-
pletely and satisfactorily, we have developed a historic
body of theoretical economics which deals with "tenden-
cies"; i.e., with what "would" happen under simplified
conditions never realized, but always more or less closely
approached in practice. But theoretical economics has
been much less successful than theoretical physics in
making the procedure useful, largely because it has failed
to make its nature and limitations explicit and clear. It
studies what would happen under "perfect competition,"
noting betimes respects in which competition is not per-
fect; but much remains to be done to establish a systematic
and coherent view of what is necessary to perfect competi-
tion, just how far and in.what ways its conditions deviate
from those of real life and what "corrections" have ac-
cordingly to be made in applying its conclusions to actual
situations.'
The vague and unsettled state of ideas on this subject is
manifest in the difference of opinion rife among economists
as to the meaning and use of theoretical methods. At
one extreme we have mathematical economists and pure
theorists 2 to whom little if anything outside of a closed
SCf. Mackenzie, Introduction to Social Philosophy, p. 58. Also Bagehot,
Economic Studies, no. 1: "The Presuppositions of English Political
Economy."
2 There are three types or schools of mathematical economic theory,









6 RISK, UNCERTAINTY, AND PROFIT
system of deductions from a very small number of prem-
ises assumed as universal laws is to be regarded as
scientific economics at all. At the other extreme there is
certainly a strong and perhaps growing tendency to re-
pudiate abstraction and deduction altogether, and insist
upon a purely objective, descriptive science. And in be-
tween are all shades of opinion.
In the present writer's view the correct "middle way"
between these extreme views, doing justice to both, is not
hard to find. An abstract deductive system is only one
small division of the great domain of economic science,
but there is opportunity and the greatest necessity for
cultivating that field. Indeed, in our analogy, theoret-
ical mechanics is a very small section of the science of
physical nature; but it is a very fundamental section, in a
sense the "first" of all, the foundation and prerequisite of
those that follow. And this also may very well hold good
of a body of "pure theory" in economics; it may be that a
small step, but the first step, toward a practical compre-
hension of the social system is to isolate and follow out to
their logical conclusion a relatively small number of fun-
damental tendencies discoverable in it. There is abundant
need for the use of both deduction and induction in eco-
nomics as in other sciences, if indeed the two methods are
theoretically separable. As Mill has well argued we must
reason deductively as far as possible, always collating our
conclusions with observed facts at every stage. Where the
data are too complex to handle in this way induction must
be applied and empirical laws formulated, to be connected
deductively with the general principles of "ethology"
(we should now say simply "human behavior"). Em-
connected with the names of Cournot, Jevons, and Walras respectively.
Dr. Vilfredo Pareto, of the University of Lausanne (successor of Walras),
is now the most prominent exponent of the mathematical method. Among
"literary" pure theorists, Wicksteed, Schumpeter, and Pantaleoni stand
out.
s Logic, book vi, chaps. ix and x.









IN ECONOMIC THEORY


phasis being laid on the provisos, in both cases, that in
using deduction the conclusions must be constantly checked
with facts by observation and premises revised accordingly,
while the empirical laws resulting from induction must in
turn be shown to follow from the general principles of the
science before they can be credited with much significance
or dependability, we see that there is little divergence left
between the two methods.'

The relations between deduction and induction are intimate, and a
rigid separation or contrast between the two methods is misleading. A
more careful study of the fundamentals of scientific method will be under-
taken hereafter (chapter vi). We shall see that there is ultimately no
such fact as deduction as commonly understood, that inference is from
particulars to particular, and that generalization is always tentative and
a mere labor-saving device. The fact is, however, that we can study facts
intelligently and fruitfully only in the light of hypotheses, while hypothe-
ses have value more or less in proportion to the amount of antecedent
concrete knowledge of fact on which they are based. The actual pro-
cedure of science thus consists of making and testing hypotheses. The
first hypotheses in any field are usually the impressions of "common
sense"; i.e., of that superficial knowledge forced upon intelligence by
direct contact with the world. Study, in the light of any hypothesis,
corrects or refutes the guiding generalization and suggests new points of
view, to be criticized and tested in the same way, and so the organization
of the material proceeds. The importance of generalization arises from
the fact that as our minds are built, it is nearly fruitless to attempt to
observe phenomena unless we approach them with questions to be an-
swered. This is what a hypothesis really is, a question. Superficial ob-
servation suggests questions which study answers. If and so long as it
answers a question affirmatively and the answer is not contradicted by
the test of practical application or casual observation, we have a law of
nature, a truth about our environment which enables us to react intelli-
gently to it in our conduct.
There is, then, little if any use for induction in the Baconian sense of an
exhaustive collection and collation of facts, though in some cases this
may be necessary and fruitful. On the other hand, there is equally little
use for deduction taken as doing more than suggesting hypotheses, sub-
ject to verification. It is to be noted, however, that our common-sense
generalizations have a very high degree of certainty in some fields, giving
us, in regard to the external world, for instance, the "axioms" of mathe-
matics. Even more important in the present connection is the r6le of
common sense or intuition in the study of human phenomena. Observa-
tion and intuition are, indeed, hardly distinguishable operations in much
of the field of human behavior. Our knowledge of ourselves is based on









8 RISK, UNCERTAINTY, AND PROFIT

The method of economics is simply that of any field of
inquiry where analysis is in any degree applicable and any-
thing more than mere description possible. It is the scien-
tific method, the method of successive approximations.1
The study will begin with a theoretical branch dealing with
only the most general aspects of the subject matter, and
proceed downward through a succession of principles ap-
plicable to more and more restricted classes of phenomena.
How far the process is carried will be a matter of taste and
of the practical requirements of any problem. In science
generally it does not pay to elaborate laws of a very great
degree of accuracy of detail. When the number of factors
taken into account in deduction becomes large, the process
rapidly becomes unmanageable and errors creep in, while
the results lose in generality of application more signifi-
cance than they gain by the closeness of approximation to
fact in a given case. It is better to stop dealing with ele-
introspective observation, but is so direct that it may be called intuitive.
Its extension to our fellow human beings is also based upon the interpre-
tation of the communicative signs of speech, gesture, facial expression,
etc., far more than upon direct observation of behavior, and this process
of interpretation is highly instinctive and subconscious in character.
Many of the fundamental laws of economics are therefore properly "in-
tuitive" to begin with, though of course always subject to correction by
induction in the ordinary sense of observation and statistical treatment
of data.
These brief statements must not be thought of as dealing with philo-
sophical problems. The writer is, like Mill, an empiricist, holding that all
general truths or axioms are ultimately inductions from experience. By
induction as a method is meant deliberate, scientific induction, the planned
study of instances for the purpose of ascertaining their "law." And de-
duction means reaching new truth by the application of general laws to
particular cases. In the present view both of these processes are regarded
as suggestive merely, exhaustive induction and conclusive deduction be-
ing alike impossible.
i The reader will recall Comte's arrangement of the sciences in the
order of generality of the principles they establish. Mathematics, the
properties of space and of quantity in the abstract, is applicable to all
phenomena and tells us correspondingly little about any of them.
The laws of matter, of living matter, etc., are less general and more con-
cretely real. The same principles are applicable within any grand divi-
sion of knowledge.








IN ECONOMIC THEORY


ments separately before they get too numerous and deal
with the final stages of the approximation by applying
corrections empirically determined.
The theoretical method in its pure form consists, then,
in the complete and separate study of general principles,
with the rigid exclusion of all fluctuations, modifications,
and accidents of all sorts due to the influence of factors
less general than those under investigation at any particular
stage of the inquiry. Our question relates to the advisability
of using this method in a tolerably rigid form in economics.
The answer to this question depends on whether in the
phenomena to be studied general principles can in fact be
found of sufficient constancy and importance to justify
their careful isolation and separate study. The writer is
strongly of the opinion that the question must be an-
swered affirmatively. Economics is the study of a particu-
lar form of organization of human want-satisfying activity
which has become prevalent in Western nations and spread
over the greater part of the field of conduct. It is called
free enterprise or the competitive system. It is obviously
not at all completely or perfectly competitive, but just as
indisputably its general principles are those of free com-
petition. Under these circumstances the study, as a first
approximation, of a perfectly competitive system; in which
the multitudinous degrees and kinds of divergences are
eliminated by abstraction, is clearly indicated. The method
is particularly indicated in a practical sense because our
most important questions of social policy hinge directly
upon the question of the character of the "natural" results
of competition, and take the form of queries as to whether
the tendencies of competition are to be furthered and sup-
plemented or obstructed and replaced.
That such a theoretical first approximation is indicated
in a theoretical sense, that it is the natural logical way of
going at the problem, conforming to the workings of our
thought processes, is sufficiently evidenced by the fact that









10 RISK, UNCERTAINTY, AND PROFIT

this is what economists have always in fact done, ever since
there has been such a science or such a social system to
be studied. They have, to be sure, been criticized for do-
ing it, and severely. But in the present writer's judgment
theorists of the past and present are to be justly criti-
cized not for following the theoretical method and studying
a simplified and idealized form of competitive organi-
zation, but for not following it in a sufficiently self-
conscious, critical, and explicit way. In their discussions
of methodology the historic economists have, indeed, been
as clear and explicit as could be desired,' but in the use
of the method as much cannot, unfortunately, be said.
It should go without saying that in the use of the scienti-
fic method of reasoning from simplified premises, it is im-
perative that it be clear to the reasoner and be made un-
mistakable to those who use his work what his procedure
is and what presuppositions are involved. Two supreme
difficulties have underlain controversies regarding method
in the past. The first is the strong aversion of the masses
of humanity, including even a large proportion of "schol-
ars, to all thinking in general terms. The second difficulty,
on the other side, is the fact referred to above, that the
persons employing methods of approximation in econom-
ics have not themselves adequately and always recognized,
and still less have they made clear to their readers, the
approximate character of their conclusions, as descriptions
of tendency only, but have frequently hastened to base
principles of social and business policy upon very incom-
plete data. The evil results of the failure to emphasize the
theoretical character of economic speculation are apparent
1 Cf. Mill's Essays on Unsettled Questions, no. 5, which really leaves
little to be said on the subject. Also Cairnes, on the Character and Logical
Method of Political Economy, and the discussions of methodology of the
English economists generally. The conception of the "economic man"
was one way of emphasizing the abstract and simplified character of the
premises of the science. Keynes's Scope and Logical Method of Political
Economy is an admirably clear and conclusive discussion of this whole
subject.








IN ECONOMIC THEORY


in every field of practical economics. The theorist not
having definite assumptions clearly in mind in working
out the "principles," it is but natural that he, and still
more the practical workers building upon his foundations,
should forget that unreal assumptions were made, and
should take the principles over bodily, apply them to con-
crete cases, and draw sweeping and wholly unwarranted
conclusions from them. The clearly untenable and often
vicious character of such deductions naturally works to
discredit theory itself. This, of course, is wrong; we do not
allow perpetual motion schemes to discredit theoretical
mechanics, which is built upon the assumption of perpetual
motion at every stage. But in economics a distrust of
general principles, fatal as it is to clear thinking, will be in-
evitable as long as the postulates of theory are so nebulous
and shifting. They can hardly be made sufficiently explicit;
it is imperative that the contrast between these simplified
assumptions and the complex facts of life be made as con-
spicuous and as familiar as has been done in mechanics.
The present essay is an attempt in the direction in-
dicated above. We shall endeavor to search out and plac-
ard the unrealities of the postulates of theoretical econom-
ics, not for the purpose of discrediting the doctrine, but
with a view to making clear its theoretical limitations.
There are several reasons why the approximate character
of theoretical economic laws and their inapplicability
without empirical correction to real situations should be
especially emphasized as compared, for instance, with
those of mechanics. The first reason is historical and has
already been indicated. The limitations of the results
have not always been clear, and theorists themselves as
well as writers in practical economics and statecraft have
carelessly used them without regard for the corrections
necessary to make them fit concrete facts. Policies must
fail, and fail disastrously, which are based on perpetual
motion reasoning without the recognition that it is such.









12 RISK, UNCERTAINTY, AND PROFIT

In the second place, the allowances and corrections
necessary in the case of theoretical economics are vastly
greater than in the case of mechanics, and the importance
of not losing sight of them is correspondingly accentuated.
The general principles do not bring us so close to reality;
there is a larger proportion of factors in an economic situa-
tion which are of the variable and fluctuating sort.
Again, in spite of the greater contrast between theory
and practice in the study of the mechanics of competition,
as compared with the mechanics of matter and motion,
the contrast is less familiar and more easily overlooked.
Our race has been observing and handling in a rude way
the latter type of phenomena ever since it has lived on the
earth, while competitive relations among men were es-
tablished only a few generations ago. In consequence the
habit of clear thinking according to scientific method, the
use of hypotheses and separation of fundamental princi-
ples from the accidents of particular instances, has become
in some measure built up in the minds of at least a respect-
able body of the more cultivated division of the race. Per-
haps it is even in some degree instinctive in certain strains.1
Finally, it makes vastly more difference practically
whether we disseminate correct ideas among the people at
large in the field of human relations than is the case with
1 It is necessary to admit that in fact only a pitifully small fraction of
the race have any particular theoretical sense in -the mechanical field
either. Certainly a vast majority of literate adults with elementary ex-
perience with machinery have no real comprehension of the most funda-
mental principles of the transformation and equivalence of forces. As
far as their own insight is concerned, they could easily be taken in with
crude perpetual motion schemes, and an astonishing proportion are will-
ing to back their own judgment in such matters against what they know
to be the unanimous verdict of the scientific world. The recurrent dis-
cussion of such projects in our National Congress are familiar. A certain
mechanical handinesss" is probably all that is to be found in any but the
rare scientific minds, and these handy men are precisely the ones who
seem most likely to waste their lives and means over palpably absurd
enterprises. A large proportion even of competent engineers have neither
comprehension nor appreciation of physical theory.








IN ECONOMIC THEORY


mechanical problems. For good or ill, we are committed
to the policy of democratic control in the former case, and
are not likely to resort to it in the latter. As far as material
results are concerned, it is relatively unimportant whether
people generally believe in their hearts that energy can be
manufactured or that a cannon ball will sink part of the
way to the bottom of the ocean and remain suspended, or
any other fundamental misconception. We have here at
least established the tradition that knowledge and train-
ing count and have persuaded the ignorant to defer to the
judgment of the informed. In the field of natural science
the masses can and will gladly take and use and construct
appliances in regard to whose scientific basis they are as
ignorant as they are indifferent. It is usually possible to
demonstrate such things on a moderate scale, and literally
to knock men down with "results." In the field of social
science, however, fortunately or unfortunately, these things
are not true. Our whole established tradition tends to the
view that "Tom, Dick, and Harry" know as much about
it as any "highbrow"; the ignorant will not in general de-
fer to the opinion of the informed, and in the absence of
voluntary deference it is usually impossible to give an
objective demonstration. If our social science is to yield
fruits in an improved quality of human life, it must for the
most part be "sold" to the masses first. The necessity of
making its literature not merely accurate and convincing,
but as nearly "fool-proof" as possible, is therefore mani-
fest.
Whether or not the use of the method of exact science is
as necessary in the field of social phenomena as the present
writer believes, it will doubtless be conceded, even by op-
ponents of this view, that it has been employed in the great
mass of the literature since the modern science of economics
was founded. It may also be granted that the terminology,
concepts, and modes of thinking in our economic instruc-
tion and in general discussion are and for a long time must








14 RISK, UNCERTAINTY, AND PROFIT
be largely dominated by the established tradition. And it
will certainly not be denied that if the method of reason-
ing from hypothetical or simplified premises is followed,
its use must be thoroughly safeguarded by emphasizing the
character of the premises and the consequent conditional
or approximate validity of the conclusions reached. If,
finally, it is admitted that this has not been adequately
done hitherto, and that mischief and misunderstanding
have followed from the loose use of assumptions and looser
application of conclusions, then the call for such a study as
the present will be established.
The tendency toward a sharper separation of the theo-
retical portion of economics from the empirical portion,
and toward the clearer formulation of premises, can be
traced in the literature of the subject, and notable progress
in the right direction has recently been made. The work of
the mathematical economists and non-mathematical pure
theorists has already been mentioned. A considerable and
fairly satisfactory body of consciously and rigidly "theoret-
ical" (i.e., general and approximate) doctrine has been
built up. The work of Pareto and Wicksteed seems to the
writer especially worthy of note. Unfortunately it has not
achieved the recognition and been accorded the funda-
mental place in the general program of the science which
we think it should have; mathematical economics in par-
ticular seems likely to remain little more than a cult, a
closed book to all except a few of the "initiated." In the
great mass of economic literature there is certainly still
wanting the evidence of a comprehensive grasp of general
principles and even more of the meaning and importance
of general principles in a scientific program. There is still
a need for thoroughgoing and critical comparison and con-
trast of theoretical assumptions with the conditions of real
life and of theoretical conclusions with concrete facts.
The makers and users of economic analysis have in general
still to be made to see that deductions from theory are








IN ECONOMIC THEORY


necessary, not because literally true that in the strict
sense they are useful because not literally true but only
if they bear a certain relation to literal truth and if all who
work with them constantly bear in mind what that relation
is. It must be admitted that even the pure theorists have
not generally been assiduous in emphasizing the practical
significance of their work and its relation to the outside
body of the science; they have been too exclusively inter-
ested in the construction of their a priori systems, and per-
haps a little disposed to regard these as a disproportionate
part of economic science. Such a bias is natural and even
useful, but in a field where the relations between theory
and practice do not come instinctively to the minds of the
users of both, the supplementation of theory by works of
interpretation becomes indispensable.
Indication of progress in this field is furnished especially
by the discussion centering around the concept of normal-
ity in the work of Marshall in England and the related
notion of the static state espoused in particular in this
country by J. B. Clark.' The meaning and bearings of the
fundamental concepts are in the writer's opinion much
better worked out by Marshall than by any other writer
generally read. But Marshall himself has adopted a
cautious, almost anti-theoretical attitude toward funda-
mentals; he refuses to lay down and follow rigidly defined
hypotheses, but insists on sticking as closely as possible
to concrete reality and discussing "representative" con-
ditions as opposed to limiting tendencies. The gain in con-
creteness and realism is in our opinion much more than
offset by the obscurity, vagueness, and unsystematic
character of the discussion, the inevitable consequence of
burying fundamentals in an overwhelming mass of quali-
fication and detail. Professor Clark, on the other hand, is
frankly theoretical and insistent upon the deliberate use of
I The static state idea is further developed along rigidly theoretical
lines by Professor Schumpeter in Austria.








16 RISK, UNCERTAINTY, AND PROFIT
abstraction. But the writer at least is unable to agree with
him on the question of what abstractions should be made
and the manner of their use. While the specifications for his
theoretical state are more definite and explicit than those
of Marshall, they seem to us less correctly drawn up.1
The opposition to pure theory in general is based on a
failure to understand it, and especially common is the mis-
conception as to the meaning of static or normal hypothe-
ses. It is not recognized that their use is inherent in the
methodology of science, is in fact the very essence of
scientific procedure; that it is not at all recondite or in-
tellectual in its appeal, but is mere practical common
sense. The aim of science is to predict the future for the
purpose of making our conduct intelligent.2 Intelligence
predicts, as shown above, through analysis, by isolating
the different forces or tendencies in a situation and study-
ing the character and effects of each separately. Static
method and reasoning are therefore coextensive. We have
no way of discussing a force or change except to describe its
effects or results under given conditions.
The "static" method in economics does merely this.
It inquires what conditions exist and studies the results
which recognizable forces at work (or changes in progress-
we know nothing about force; it is the assumed "cause" of
change, which is the only fact) tend to produce under those
conditions. It is "unreal" only in the simplification of its
problem; i.e., in taking the more conspicuous forces and
more important conditions and provisionally neglecting
others. This the limitations of our minds compel us to do.
We must first discuss one change at a time, assuming the
others suspended while that one is working itself out to its
final results, and then attempt to combine the tendencies at
SWe shall attempt to show that it does not represent, as Professor
Clark contends, the assumptions implicit in the classical economic theory.
(See chapter in.)
2 Cf. Dewey's definition of reason as the method of social diagnosis
and prognosis.








IN ECONOMIC THEORY


work, estimate their relative importance, and make actual
predictions. This is the way our minds work; we must
divide to conquer. Where a complex situation can be
dealt with as a whole if that ever happens there is no
occasion for "thought." Thought in the scientific sense,
and analysis, are the same thing.
The reference to final results calls for a further word.
The concept of equilibrium is closely related to that of
static method. It is the nature of every change in the
universe known to science to have "final" results under
any given conditions, and the description of the change is
incomplete if it stops short of the statement of these ul-
timate tendencies. Every movement in the world is and
can be clearly seen to be a progress toward an equilib-
rium. Water seeks its level, air moves toward an equality
of pressure, electricity toward a uniform potential, radia-
tion toward a uniform temperature, etc. Every change is an
equalization of the forces which produce that change, and
tends to bring about a condition in which the change will
no longer take place. The water continues to flow, the
wind to blow, etc., only because the sun's heat itself a
similar but more long-drawn-out redistribution of energy
- constantly restores the inequalities which these move-
ments themselves constantly destroy.
So also in economic phenomena. Goods move from the
point of lower to one of higher demand or price, and every
such movement obliterates the price difference which
causes it. The circulation of goods continues because the
life activities of man (the production of wealth) keep new
supplies forthcoming. The same applies to shifts in pro-
ductive energy from one use to another. There are really
as many static states as there are changes to be studied,
sets of given conditions to be assumed. It is arbitrary but
convenient to speak of the static state in relation to given
conditions of the supply and demand (production and
consumption) of consumption goods. We shall see that









18 RISK, UNCERTAINTY, AND PROFIT

there are in fact two other fundamental static problems; the
first assumes given supplies of consumption goods, and the
second, given general conditions under which the creation
of production goods and changes in wants take place; the
first is the problem of the market or of market price, and
the second that of social economic progress, often referred
to as economic dynamics.
The argument of the present essay will center around
the general idea of normality, viewed as an attempt to
isolate for study the essentials or general principles of a
competitive social economic organization. The aim will be
to bring out the content of the assumptions or hypotheses
of the historic body of economic thought, referred to by
the classical writers as "natural price" theory. By this is
meant, not the assumptions definitely in the minds of the
classical economists, but the assumptions necessary to
define the conditions of perfect competition, at which the
classical thought was aimed, and which are significant as
forming the limiting tendency of actual economic proc-
esses.'
As the title of the essay indicates, our task will be en-
visaged from the immediate standpoint of the problem of
profit in distributive theory. The primary attribute of
competition, universally recognized and evident at a
glance, is the "tendency" to eliminate profit 2 or loss, and
bring the value of economic goods to equality with their
cost. Or, since costs are in the large identical with the

'We need not here more than mention the obvious fact that the
theoretical method is applicable to monopoly as well as competition
and has dealt with both. It has been, of course, a theoretically "ideal"
monopoly also the real assumption being an exceptional instance of
perfect monopoly in .a general system of perfect competition. The con-
trast between theory and reality and the significance of the former is of
the same sort in both cases, and we shall also discuss the meaning of per-
fect monopoly in the proper connection. (Chapter vi.)
2 It will be perceived that the word "profit" is here used in the sense
of "pure profit," a distributive share different from the returns to the
productive services of land, labor, and capital.








IN ECONOMIC THEORY


distributive shares other than profit, we may express the
same principle by saying that the tendency is toward a
remainderless distribution of products among the agencies
contributing to their production. But in actual society,
cost and value only "tend" to equality; it is only by an
occasional accident that they are precisely equal in fact;
they are usually separated by a margin of "profit," posi-
tive or negative. Hence the problem of profit is one way of
looking at the problem of the contrast between perfect
competition and actual competition.
Our preliminary examination of the problem of profit
will show, however, that the difficulties in this field have
arisen from a confusion of ideas which goes deep down into
the foundations of our thinking. The key to the whole
tangle will be found to lie in the notion of risk or uncer-
tainty and the ambiguities concealed therein. It is around
this idea, therefore, that our main argument will finally
center. A satisfactory explanation of profit will bring into
relief the nature of the distinction between the perfect
competition of theory and the remote approach which is
made to it by the actual competition of, say, twentieth-
century United States; and the answer to this twofold
problem is to be found in a thorough examination and
criticism of the concept of Uncertainty, and its bearings
upon economic processes.
But Uncertainty must be taken in a sense radically
distinct from the familiar notion of Risk, from which it
has never been properly separated. The term "risk," as
loosely used in everyday speech and in economic dis-
cussion, really covers two things which, functionally at
least, in their causal relations to the phenomena of
economic organization, are categorically different. The
nature of this confusion will be dealt with at length in
chapter vii, but the essence of it may be stated in a few
words at this point. The essential fact is that "risk"
means in some cases a quantity susceptible of measure-








20 RISK, UNCERTAINTY, AND PROFIT
ment, while at other times it is something distinctly not of
this character; and there are far-reaching and crucial differ-
ences in the bearings of the phenomenon depending on
which of the two is really present and operating. There are
other ambiguities in the term "risk" as well, which will be
pointed out; but this is the most important. It will appear
that a measurable uncertainty, or risk proper, as we shall
use the term, is so far different from an unmeasurable one
that it is not in effect an uncertainty at all. We shall
accordingly restrict the term "uncertainty" to cases of the
non-quantitive type. It is this "true" uncertainty, and
not risk, as has been argued, which forms the basis of a
valid theory of profit and accounts for the divergence be-
tween actual and theoretical competition.
As a background for the discussion of the meaning and
causal relations of uncertainty, we shall first make a brief
survey of previously proposed theories of profit. After a
summary glance at the history of the treatment of the sub-
ject down to recent decades, it will be necessary to dwell at
slightly greater length upon the controversy recently car-
ried on in connection with the explanation of profit in
terms of risk. The crucial character of the distinction
between measurable risk and unmeasurable uncertainty
will become apparent in this discussion.
Part Two (chapters mi-vi) will be taken up with an out-
line study of a theoretical, perfectly competitive society.
In the course of the argument it will become increasingly
evident that the prime essential to that perfect competition
which would secure in fact those results to which actual
competition only "tends," is the absence of Uncertainty
(in the true, unmeasurable sense). Other presuppositions
are mostly included in or subordinate to this, that men
must know what they are doing, and not merely guess more
or less accurately. The "tendency" toward perfect com-
petition is at once explained, since men are creatures en-
dowed with the capacity to learn, and tend to find out the








IN ECONOMIC THEORY


results of their acts, while the cause of the failure ever to
reach the goal is equally evident so long as omniscience
remains unattainable. Now since risk, in the ordinary
sense, does not preclude perfect planning (for reasons
which can easily be made clear), such risk cannot pre-
vent the complete realization of the tendencies of competi-
tive forces, or give rise to profit.
At the conclusion of this brief treatment of perfect com-
petition we shall devote a short chapter to limitations of
perfect competition other than the imperfection of knowl-
edge, and then take up in Part Three a careful analysis of
the concepts of Risk and Uncertainty (chapter vi), pro-
ceeding (in the remaining chapters) with a somewhat de-
tailed study of the effects of both, but especially of true or
unmeasurable uncertainty upon the economic organization
and of its bearings upon economic theory. The economic
relations of risk in the narrower sense of a measurable prob-
ability have been extensively dealt with in the literature of
the subject and do not call for elaborate treatment here.
Our main concern will be with the contrast between Risk
as a known chance and true Uncertainty, and treatment
of the former is incidental to this purpose.














CHAPTER I


THEORIES OF PROFIT; CHANGE AND RISK IN
RELATION TO PROFIT

IN view of the facts set forth in the introductory chapter
as to the relation of profit to theoretical economics, and the
vagueness in the minds of economic writers as to funda-
mental postulates, it is not surprising that the theory of
profit has remained one of the most unsatisfactory and
controversial divisions of economic doctrine. Considering,
however, the universal recognition of the "tendency" of
competition to eliminate profit, it is perhaps somewhat re-
markable that the problem of profit itself has not, with one
important exception,2 been attacked from the direct point
of view adopted in this essay, of an inquiry into the causes
of the failure of ideal competition to be fully realized in fact.
It is, indeed, only within comparatively recent years that
the existence of profit as a really distinct share has become
established and the problem of its explanation given de-
finite status.
As in the case of most sciences whose subject matter is
some field of human activity, economic theory has been
much influenced by practice, and in particular the loose use
1 Excellent histories of profit theory are to be found in the introduc-
tory sections of several monographs on profit and make it superfluous to
go into this phase of the subject in detail. See especially the following:
Mangoldt, H. v., Die Lehre vom Unternehmergewinn. Leipsic, 1855.
Pierstorff, J., Die Lehre vomr Unternehmergewinn. Berlin, 1875.
Mataja, V., Der Unternehmergewinn. Vienna, 1884.
Gross, G., Die Lehre von Unternehmergewinn. Leipsic, 1884.
Porte, M., Entrepreneurs et profits industries. Paris, 1901.
2 The exception is Professor Clark's theory of perfect competition as
equivalent to the "static state" and the corresponding "dynamic
theory of profit as the result of progress. This view will presently be
taken up and criticized.








THEORIES OF PROFIT


of terms in everyday affairs has given rise to serious con-
fusions in terminology. The concept of profit is bound up
in a certain type of organization of industry, a type realized
in various degrees in different places and times, and always
undergoing modification and development.
At the time when the English classical school of eco-
nomists were writing i.e., in the later eighteenth and
early nineteenth centuries corporations were relatively
unimportant, being practically restricted to a few banks
and trading companies. There was, of course, some lend-
ing at interest, but in the dominant form of industry men
used their own capital, hiring labor and renting land from
others. The managerial function centered in the capital-
ist. Moreover, English industries were new and rapidly
expanding; competition was not highly developed; the
possession of capital seemed to be and was the dominant
factor in the situation. Only in more recent times has the
accumulation of capital, the perfection of financial institu-
tions, and the growth of competition transferred the center
of interest to business ability, made it easy or at least
generally possible for ability to secure capital when not in
possession of it by direct ownership, and made common
the carrying-on of business predominantly with borrowed
resources.
Under these early conditions it was natural to connect
the income of the business manager with the ownership of
capital, and in all the classical writings we find the word
"profit" used in this sense. A further source of confusion
was the indefiniteness of the conception and use of the
ideas of natural and market price in the minds of the early
writers. It is natural and inevitable that a distinction
which goes to the heart of the fundamental problems of the
nature and methodology of economic science should be
but imperfectly worked out in the initial stages of the
speculation. Only recently, again, has the analysis of
long-time normal price by Marshall and of the "static









24 RISK, UNCERTAINTY, AND PROFIT

state" by Clark and Schumpeter begun to give to econo-
mists a clearer notion of what is really involved in "natu-
ral" or normal conditions. To the earlier classical writers
this obscurity hid the fundamental difference between the
total income of the capitalist manager and contract in-
terest. The only separation considered necessary in the
explanation of distribution was to restrict the theory of the
business manager's income to the explanation of "normal
profit," which was regarded as substantially equivalent to
contract interest. Another barrier to the formulation of a
clear statement of the relations between interest and pro-
fit was the lack of an adequate understanding of the pro-
ductivity of capital, which also these authors did not pos-
sess and which has first been worked out in recent years.
The qualification of "near" or "substantial" identifica-
tion of normal profit and interest is necessary, however, in
referring to the classical treatments. Even Adam Smith
and his immediate followers recognized that profits even
normally contain an element which is not interest on capi-
tal. Remuneration for the work and care of supervising
the business was always distinguished. Reference was also
made to risk, but in the sense of risk of loss of capital, which
does not clearly distinguish profit from interest.' Adam
Smith is explicit in regard to these elements, while Malthus
and M'Culloch were more so. J. S. Mill pointed out in
a somewhat groping way that the wages of management
are determined in a different way from other wages, and
1 For a fuller discussion of the views of the English writers, with cita-
tions, see Cannan, Theories of Production and Distribution, chap. vi,
see. 2; also the same author's article on "Profit" in Palgrave's Dictionary
of Political Economy. In opposition to the German historians and critics,
who take the classical economists very literally, Cannan is sure that they
really held, like their French followers, a wage theory of profit. Between
the two views this seems the fairer on the whole, but it could hardly be
maintained that the difference in expression does not represent some
difference in thought. However, much of the contrast is undoubtedly
due to differences in 'the use of terms. Old words used to designate new
things necessarily become ambiguous, and "profit" is still correctly used
with several different meanings.








THEORIES OF PROFIT


noted also that profits, so called, include as a third ele-
ment a payment for risk, as well as wages of management
(and interest). The inclusion of interest in profit was op-
posed by Bagehot, and in the United States by Walker,
but the use of the term is still somewhat loose in England,
as is seen in Marshall. Even in this country the develop-
ment of corporation accounting, while separating wages of
management from profit, has tended to a new confusion of
profit and interest.
The early French writers, beginning with J. B. Say,
adopted a different view of profit, or at least a different
use of the word, insisting on a separation of profit from in-
terest and defining the former explicitly as a wage. The
difference in procedure may have been due, as v. Man-
goldt suggests,1 to the different character of typical French
industry and the greater importance of the manager's
personality in it relatively to the capital factor. It is
worthy of note that in the fourth edition of his "Trait6,"
Say included in profit the reward for risk-taking; he had in
the earlier editions viewed this income as accruing to the
capitalist as such, but now transferred it to the entrepre-
neur. Especial mention should be made of Courcelle-
Seneuil, who insisted that profit is not a wage, but is due to
the assumption of risk.2
The older German economists varied widely in their
SOp. cit., p. 19, note.
2 Article, "Profit," in Coquelin and Guillaumin's Dictionnaire de
rTconomie politique, Paris, 1852. It is true that in another work (TraitM
d'iconomie politique, 2d ed., 1867) Courcelle was not so explicit, and also
that in the same article he says that profit depends on the intelligence of
the entrepreneur and the favorable or unfavorable conditions under which
he works. This hesitation may explain KleinwUchter's classifying him
with the followers of Say and adherents ot the wages theory. (See Das
Einkommen und seine Verteilung, p. 278.) It seems more probable, how-
ever, that Courcelle glimpsed the fact (which Kleinwachter did not) that
the assumption of a "risk" of error in one's own judgment, inherent in
the making of a responsible decision, is a phenomenon of a different char-
acter from the assumption of "risk" in the insurance sense. We shall
build largely upon this distinction later.









w2 RISK, UNCERTAINTY, AND PROFIT

treatment of profits. Some, of whom Schliffe is perhaps
the most notable example, follow the "English" view in
classing profit as essentially a return to capital. Others,
notably Roscher, adopt the "French"1 attitude and treat
it as a form of wages. Roscher does not even use the term
"profit," but substitutes Unternehmerlohn. Other writers,
such as Hermann and Rau, took a more or less intermediate
position.
Still another group, of more importance for our purposes,
contended that profit should be recognized as a unique
form of income, not susceptible of reduction to remunera-
tion for either capital or labor. This position was taken in a
somewhat timid way by Hufeland 2 and more definitely by
Riedel, a but its most notable advocates were Thtinen and
v. Mangoldt. Thiinen's great work, "Der Isolirte Staat,"4
defines profit as what is left after (a) interest, (b) insurance,
and (c) wages of management, are met. This residuum con-
sists of two parts: (1) payment for certain risks, especially
changes in values and the chance of failure of the whole
enterprise, which cannot be insured against, and (2) the
extra productivity of the manager's labor due to the fact
that he is working for himself, his "sleepless nights" when
he is planning for the business. Thtinen called these ele-
1 These national designations of the two schools hold closely. The
only notable exceptions (aside from Courcelle) are on the one side, Rossi.
a French (naturalized Italian) writer, who strongly espoused the capital-
istic or English view, and on the other Samuel Read, who, while agreeing
with the current English treatment in terminology, broke with it in sub-
stance and agreed with Say and his followers. Read insisted on identify-
ing "profit" with the return to capital, or interest, and treating the dis-
tinctive income of the entrepreneur as a wage. He also emphasized the
"compensation for risk" element in his "profit" (really interest), but
thought it due to no determinate causes and "outside the pale of science."
This last phrase shows at least an insight into the unique character of
this sort of risk, since the assertion would certainly not have been made of
an insurance premium. See his Political Economy, Edinburgh, 1829, pp.
263 and 269, note.
s Neue Grundlage der Staatswissenschaft, vol. I. Giessen, 1807.
National Okonomie, 1839.
4 Appeared 1826. Sd ed., 1876. See 3d ed., vol. n, pp. 83 ff.








THEORIES OF PROFIT


ments respectively Industriebelohnung and Unternehmer-
gewinn, and their sum Gewerbsprofit.
A most careful and exhaustive analysis of profit is con-
tained in the monograph of H. v. Mangoldt, already re-
ferred to. Proceeding on the basis of an elaborate classifi-
cation of the forms of industrial organization and a dis-
cussion of the economic advantages of the entrepreneur
form, this writer finds in the income of the business enter-
priser a complex group of unique elements. He divides it
first into three parts: (1) a premium on those risks which
are of such a nature that he cannot shift them by insurance;
(2) entrepreneur interest and wages, including only pay-
ments for special forms of capital or productive effort which
do not admit of exploitation by any other than their owner;
(3) entrepreneur rents. These last again fall into four sub-
divisions: (a) capital rents, (b) wage rents, (c) large enter-
prise rent, and (d) "entrepreneur rent in the narrower
sense." They are all due to the limitation of special capac-
ities or characteristics (the last to special combinations of
such) and are called "premiums on scarcity" (Seltenheits-
prdmeien). This is, of course, a question-begging term
(though many writers have used it) since all incomes de-
pend in the same way on the limitation of the agencies to
which they are imputed. It would seem that every im-
aginable source of income is included in this minute and
subtle classification.
A special place in the history of theories of profit should
be given to the German socialist school, the so-called
"scientific" socialists, Rodbertus, Marx, Engels. Lassalle,
and their followers. These writers take the English classi-
cal treatment of profit in a narrowly literal (one must say
wholly uncritical and superficial) sense as including all in-
come accruing to capital, to which they add land. Com-
bining this with an equally blind reading of the labor theory
of value which was the starting-point of Smith and Ricardo,
they derive a simple classification of income in which all









28 RISK, UNCERTAINTY, AND PROFIT

that is not wages is a profit which represents exploitation
of the working classes. Capital is equivalent to property,
which is to be regarded as mere power over the economic
activities of others due to the strategic position of owner-
ship over the implements of labor. It is analogous to a
robber baron's crag, a toll-gate on a natural highway, or a
political franchise to exploit. Pierstorff, in the monograph
referred to above, follows Rodbertus in the main, after
criticizing alternative views.'
After the publication in 1871 of Menger's "Grund-
sttze" had given a new interest and new turn to vahie
theory in Austria and Germany, a notable series of dis
cussions of profit appeared in those countries. Those call-
ing for especial mention are the monographs of Gross 2
and Mataja 3 and the treatments by Mithoff 4 and Klein-
witchter 6 in Schtinberg's "Handbuch," the last-named
elaborated in the author's book already referred to. Gross
takes as his starting-point the plain fact that profit is the
difference between the cost of goods and their value, and
studies the position of the entrepreneur in the two markets
in which he buys productive services and raw materials and
sells his finished product. He may be said to reduce profit
to bargaining power, in which, of course, superior knowl-
edge and foresight are recognized as playing a large part,

1 See also the article "Unternehmergewinn," by Pierstorff in Con-
rad's Handwurterbich der Staatwissenschaften. Dr. Thorstein Veblen's
conceptions of capital and profit show strong leanings toward the same
views.
Referred to above, p. 22 n. 'Ibid.
4 G. Schanberg, Handbuch der Poltischen Okonomie, 2d ed. (THbingen,
1885), pp. 670 ff.
Ibid., pp. 220 f.
Other works in the same group with the above are:
E. Aug. Schroeder, Das Unternehmen und der UnienwAr ergewnu.
Vienna, 1884. (The same date of publication as Gross and Mataja.)
A. Wirminghaus, Das Unternehmergewinn und die Beeiligung der
Arbeiter am Unternehmergewinn. Jena, 1886.
E. Zuns, Swei Fragen des Unternehmer-Einkommens. Berlin, 1881.
A. Krner, Unternehme und Unternermergewr n. Vienna, 189.








THEORIES OF PROFIT 29
but Gross does not work out a systematic treatment of the
nature and significance of risk or uncertainty. He thinks an
income which is a premium for taking risks is inherently
impossible, as gains and losses would necessarily balance.
Few other writers agree with this proposition. Socially,
profit is for Gross the inducement to follow closely the
economic law of cheapest possible production and most
effective utilization of goods.
Mataja's analysis of profit is a more literal application
of Menger's utility theory of value. He seeks to explain
price differences by means of the differences between the
various uses of "goods of higher order" in making differ-
ent kinds of" goods of lower order and ultimately different
consumption goods. His discussion does not get beyond a
statement of the problem.
Mithoff holds that the entrepreneur's income consists of
rents, wages, etc., at market rates for the productive serv-
ices which he furnishes to the business, plus a "profit"
which may be regarded as remuneration for taking the risk
of its failure. He contends, however, that this profit is at
best a mere abstraction, a complex of a number of inde-
terminate surpluses, and that the entrepreneur income as a
whole alone has definite meaning or practical significance.
Kirner is another writer who explains the entrepreneur's
income in terms of superior bargaining power. His position
is figured as that of a watchman on a tower and is summed
up in the expression that his is a wider market than that of
the men he buys from and sells to, especially the laborer
whom he hires. The essential mystery of why the com-
petition of other watchmen on similar towers does not
eliminate his peculiar gain is not touched upon. The non-
socialistic German writers are usually particularly con-
cerned to combat the allegations of the socialists and fur-
nish a social justification of profit.
Kleinwichter views profit from the social standpoint as
pay for taking the twofold risk of production technical








0S RISK, UNCERTAINTY, AND PROFIT
and economic, a distinction made by Gross and for the
care of supervision. From the individual point of view it is
a speculative gain arising from advantage taken of differ-
ences between the prices of economic goods and the prices
of the agents necessary to their production. In his fuller
treatment in his book on distribution, Kleinwichter de-
votes most of his energy to a sarcastic polemic against the
English classical economic theory, according to which the
prices of commodities should equal their costs of produc-
tion or the sum of the wages, interest, and rent paid the
agents employed to produce them. No serious criticism of
this theory is attempted, however, nor any sign displayed
of a comprehension of its real meaning as a statement of the
limits of tendencies. The general conclusion that the exist-
ence of profit follows from a divergence between the con-
ditions of theory and those of fact is the starting-point of
the present study. It is, of course, a statement of the
problem, and not a solution of it; Kleinwichter virtually
explains profit by ridiculing the idea that it should be
thought to call for explanation.
In other than the German-speaking countries the sub-
ject of profit has not been prolific of independent mono-
graphs and treatises, but has usually been dealt with as an
integral part of the general theory of distribution (though
there are some exceptions in France and Italy which would
have to be noticed in a fuller historical treatment). It is, of
course, impossible to take up even the important theorists
in all countries and summarize their views, while any brief
treatment by schools or groups would be misleading rather
than helpful. The writers already mentioned pretty well
cover the fundamental theories and standpoints, with ex-
ceptions yet to be noted.1 A very common procedure is to
treat profit as a special case of monopoly gain, or to com-
SA noteworthy innovation in the treatment of profit has been made
by a recent French writer, M. B. Lavergne, in his Thdorie des marcdzt
&nomiques (Paris, 1910). In his view profit is the remuneration of the
ide producirice, which is elevated to the position of an independent pro.









THEORIES OF PROFIT


bine elements of monopoly position with other factors.
This method is apt to degenerate into a mere confusion of
the two income categories. The common use of the term
"monopoly profit" to designate monopoly revenue directly
incites to this confusion.
The first notable development in the field of profit theory
in America was the work of General Francis A. Walker.1
Walker effectually emphasized the place and importance of
the entrepreneur or "captain of industry," and helped to
free economic treatises in English from the careless han-
dling of profit as an element in interest. His own "rent
theory," however, in spite of its vogue at the time of its
promulgation, need not now detain us. Walker wrote be-
fore Marshall, Clark,2 and Hobson a had shown that all
incomes are like rent in the mode of their determination,
and with that point once made clear the rent theory is
reduced to a wage theory merely, and its special signifi-
cance disappears.
More recently the center of interest in the discussion of
profit has shifted from Walker's theory to two other op-
posed views, the "dynamic theory" and the "risk theory "
respectively. The former is the view upheld by Professor
J. B. Clark and his followers and the latter is sponsored in
particular by Mr. F. B. Hawley.4 Neither the connection
ductive factor. His book outlines an ingenious and suggestive theory of
distribution. See review by Professor A. A. Young, American Economic
Review, vol. I, pp. 549 ff.
I Political Economy, part rv, chap. iv. See also "The Source of Busi-
ness Profits and Reply to Mr. Macvane," Quarterly Journal of Economics,
vol. I, pp. 265 ff., and vol. n1, pp. 263 ff. (Macvane held a monopoly theory;
cf. Quarterly Journal of Economics, vol. In, pp. 1 if. and 453 ff.) A view
similar to that of Walker has been advocated in France by Leroy-Beau-
lieu (Sr.). See MEmories de l'Academie des sciences morales et politiques,
vol. I, pp. 717 if, and Traitb d'dconomie politique, part Iv, chap. Ix.
2 "Distribution as Determined by a Law of Rent," Quarterly Journal
of Economics, vol. v, pp. 289 ff.
"The Law of the Three Rents," ibid., vol. v, pp. 263 ff.
More exhaustive than either Clark or Hobson is Wicksteed, The
Coordination of the Laws rf Distribution, London, 1894.
It is not meant that these are the only noteworthy advocates of the









s2 RISK, UNCERTAINTY, AND PROFIT

between profit and changes in conditions nor that between
profit and risk is an entirely new idea, but hitherto neither
had been erected into a definite and ostensibly sufficient
principle of explanation of the peculiar income of the en-
trepreneur. These two theories call for somewhat fuller
treatment.
The dynamic theory is a correlate of Professor J. B.
Clark's theory of distribution in the profitless "static
state."' Professor Clark outlines a systematic structure of
theoretical economics in three main divisions.
The first treats of universal phenomena, and the second of
static social phenomena. Starting with those laws of economics
which act whether humanity is organized or not, we next study
the forces that depend on organization but do not depend on
progress. Finally it is necessary to study the forces of progress.
To influences that would act if society were in a stationary state,
we must add those which act only as society is thrown into a
condition of movement and disturbance. This will give us a
science of Social Economic Dynamics.2
The static state is the state of "natural" adjustments of
Ricardo and the early classical writers.
What are called "natural" standards of values and "natural"
or normal rates of wages, interest, and profits are in reality, static
rates. They are identical with those which would be realized, if
views in question, nor that other American writers on distribution have
not been in some degree original in their treatment of profit. The dis-
cussions by the various authors Davenport, Ely, Fetter, Fisher,
Johnson, Seager, Seligman, Taussig, and others are accessible every-
where. Perhaps especial mention should be made of the chapter on profit
in Carver's Distribution of Wealth. Carver's distinction between com-
pensation for risk-taking and the results of successful risk-taking points
to the direction in which a solution of the problem is to be sought. Other
writers also have seen the importance of a critical dissection of the risk
concept, but none have so far carried out the work. Unquestionably the
best of these textbook discussions is that of Professor F. M. Taylor in
his unpublished Principles of Economics, a work characterized through-
out by correctly reasoned and accurately stated theoretical argument.
1 See The Distribution of Wealth, 1900; and Essentials of Economic
Theory, 1907.
2 The Distribution of Wealth, pp. 30, 31.









THEORIES OF PROFIT


a society were perfectly organized, but were free from the dis-
turbances that progress causes.... Reduce society to a station-
ary state, let industry go on with entire freedom, make labor
and capital absolutely mobile ... and you will have a regime of
natural values.1
To realize the static state, we should have to eliminate
five kinds of change which are constantly in progress:
Five generic changes are going on, every one of which reacts
on the structure of society, by changing the arrangements of that
group system which it is the work of catallactics to study:
1. Population is increasing.
9. Capital is increasing.
8. Methods of production are improving.
4. The forms of industrial establishments are changing, the
less efficient shops, etc., are passing from the field, and the
more efficient are surviving.
5. The wants of consumers are multiplying.2

In the static state each factor secures what it produces,
and since cost and selling price are always equal there can
be no profits beyond wages for the routine work of super-
vision.
The prices of goods are in these older theories said to be
"natural" when they equal the cost of producing them;... in
reality their "natural prices" were static prices.'

The prices that conform to the cost of production are, of course,
those which give no clear profit to the entrepreneur. A business
man whose goods sell at such rates will get wages for whatever
amount of labor he may perform, and interest for any capital
that he may furnish; but he will have nothing more to show in the
way of gain. He will sell his product for what the elements that
compose it have really cost him, if his own labor and the use of
his capital be counted among the costs. We shall see that this
condition of no-profit prices exactly corresponds to the one that
would result from the static adjustment of the producing groups.4
i The Distribution of Wealth, p. s9.
Ibid., p. 56. Ibid., pp. 68-69.
4 Ibid. Professor Joseph Schumpeter, who has carried the static
analysis farther in some respects than Professor Clark, points out that in









84 RISK, UNCERTAINTY, AND PROFIT

Profits are, then, the result exclusively of dynamic
change. "Obviously, from all these changes two general
results must follow: first, values, wages and interest will
differ from the static standards; secondly, the static stand-
ards themselves will always be changing." 1 The type of
dynamic change is invention; "an invention makes it
possible to produce something more cheaply. It first gives
a profit to entrepreneurs and then ... adds something to
wages and interest.... Let another invention be made.
... It also creates a profit; and this profit, like the first, is
an elusive sum, which entrepreneurs grasp but cannot
hold." It "slips through their fingers and bestows itself on
all members of society."2 Thus the effect of any one
dynamic change is to produce temporary profits. But in
actual society such changes constantly occur, and the re-
adjustments are always in process. "As a result, we ..
have the standard of wages moving continuously upward
and actual wages steadily pursuing the standard rate in its
upward movement, but always remaining by a certain in-
terval behind it." 8
In another sense profit is dependent on "friction":
"The interval between actual wages and the static stand-
ard is the result of friction; for, if competition worked with-
out let or hindrance, pure business profit would be an-
nihilated as fast as it could be created ... ." 4 Were it not
for that interval, entrepreneurs as such would get nothing,
the static state there is no entrepreneur, properly speaking. The con-
sumer, he adds, is really the entrepreneur; but it would seem preferable
to say that the function is absent and let it go at that. (Theorie der
Wirtschaftliche Entwickelung.Y
1 The Distribution of Wealth, p. 404.
2 Ibid., p. 405. 3 Ibid., p. 406.
4 Ibid., p. 410. This is fallacious even under the assumptions, since
the profits of change come largely in the form of readjustments of capital
values. The difficulty is, of course, avoided if "friction" be so broadly
defined that "perfect mobility" means the absence of all resistance to
the human will. But in a world where a breath could transform a brick
factory building into a railway yard or an ocean greyhound there would
be no need for economic activity or economic science.




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