Chapter III

. It would be plainly foolish, for instance, to substitute

for the certainty of an income of $2500 per annum an even chance of $5000 or nothing, since the utility to us of $5000 is not twice as great as that of $2500.

The majority of business risks are not of a kind against which it is possible to insure. Insurance companies confine themselves to risks which are mainly a matter of what we call objective rather than subjective chance, i.e. risks in respect of which knowledge of detailed facts peculiar to the individual case is of minor importance. But such knowledge is of paramount importance in the case of ordinary business risks. If, for example, a new enterprise is to be undertaken, the special knowledge and experience which its promoters possess is a vital factor in determining their estimate of the risk involved. An outsider with no special knowledge would necessarily require to estimate the risk far more highly if we were to form a rational opinion on the basis of _his_ knowledge. So great, indeed, would be the risk to him, that we can lay it down as a sound maxim that people are extremely rash who invest their money in risky undertakings about which they know very little. This subjective aspect of business risk has a significance to which it will be necessary to revert.

But, though most business risks are not and cannot be a matter for premiums and policies, the principle, which the practice of insurance illustrates, applies none the less. In the light of their knowledge and experience, the promoters of a new undertaking must weigh up the chances of failure and success, though they will not do so by the precise methods of an actuary. They will require that any chances of serious loss should be balanced by such chances of exceptional gain, as would raise the _expectation_ of profit well above the normal return on secure investments. The more risky the project seems the greater, generally speaking, must be the _expectation_ of profit required to induce people to undertake it.

If we suppose business men to calculate reasonably, it follows that the average profits in any industry over a long period of years, reckoning in the losses of the concerns which disappear altogether, are likely to be higher, the more risky is the industry. Such a result will not, of course, occur in every case. Even when the calculations are reasonable, they may be entirely falsified by the event. Moreover, business men may not calculate reasonably on the information which they have. But, unless we suppose their judgment to be subject to a prevailing bias in one direction, i.e. to be unduly optimistic as a general rule, _we_ should expect, and in any case _they_ must expect, profits above the ordinary in a risky industry.

This conclusion is sufficiently important. Far too many people, though they admit it when it is expressly stated and dismiss it even as a tiresome commonplace, are apt to neglect it when the occasion for applying it arises. For example, the great importance to any industry of good management is generally recognized, and the consequent desirability of paying adequate salaries to the managerial staff. The importance of securing a supply of capital is very widely recognized, and the practical necessity of paying a fair rate of interest is thus, however grudgingly, conceded. But the "residuary profits," as they are called, which accrue at present to the owners of a business, are denounced in some quarters in a sweeping fashion, which seems to ignore altogether the all-pervading element of risk. People speak as though you might appropriately limit profits in every industry to some uniform percentage on the capital employed, without making it clear whether you would even be allowed to make up in good years for the losses incurred in bad. The effect of introducing any such crude device into our present industrial system could only be to paralyze enterprises of an unusually risky kind, which, so far from being pushed to an excess at present, are more probably curtailed unduly from the standpoint of what is socially desirable. Like the fixing of a low maximum price for a commodity it would cause the supply to wither up and disappear.

§4. _Risk under Large-scale Organization_. While this is true of the present economic system, the question is worth considering whether it represents a fundamental necessity, whether, for instance, under our world socialist commonwealth the factor of risk-bearing need play so important a part as it does in the actual business world. This question cannot be answered with a conclusive simplicity; opposing considerations present themselves, between which it is not easy to strike a balance. On the one hand, in accordance with the law of averages gains and losses tend to cancel out over a large series of transactions, _when reasonable calculations have been made_. Thus Insurance Companies, while they take heavy risks off the shoulders of policy-holders, incur relatively trifling risks themselves; they can predict the aggregate sums which they will be called upon to pay within a small margin of error. In the same way it might seem that every enlargement of the scale of business would make for an automatic insurance and a consequent economy of risk; and thus that if all businesses were comprised in a single financial unit, gains and losses would cancel out over so wide a range that the degree of risk remaining would be almost negligible.

This might indeed happen, if business risks were mainly of that objective kind in which the insurance companies specialize; for then we could assume that the chances of success or failure would be estimated reasonably. But, in fact, most business risks, not being of this kind, must be estimated by processes of human judgment, which are very fallible. And here we must take account of the law of averages in another aspect, with a different bearing on the argument. When an industry comprises a large number of separate concerns, and the decisions accordingly are taken by many men, acting independently of one another, the errors of calculation will tend to some extent to cancel one another out. The undue optimism of one man will be balanced by the undue pessimism of another; and, if there is no prevailing bias in either direction, the errors of judgment will not affect the results for the industry as a whole. But where the effective decisions are taken by very few men, the chances are far greater of a preponderating balance of error in one direction. The risks dependent on the factor of human judgment tend therefore to increase.

This truth can be illustrated by a phenomenon which is fairly familiar. It is recognized by intelligent persons that the risks of speculation in a particular commodity market or stock market increase more than proportionately to the scale of operations. A man who sets out as a "bull" upon a small scale can buy without sending up the price against him in the process, and, if he decides later that his judgment is mistaken, he can at any time cut his losses and sell out without much difficulty. But a "bull" on a very large scale cannot complete his purchases except at a price which has been raised in consequence of his own action, and he cannot count on being able to "unload" at or near the market price, should he decide to do so. If, accordingly, he miscalculates, he cannot save himself from serious loss as a smaller man might do by a prompt discovery of his error. His difficulties spring from the fundamental fact that the effects of his calculations are too great to be offset by those of the different, and often opposite, calculations of other men.

Upon the issue whether a growth in the size of the business unit is likely to diminish risk, the law of averages thus cuts both ways. The risks arising from the element of pure chance are more likely, those arising from miscalculation are less likely, to cancel out. Upon these grounds alone, it would be unsafe to conclude that there would be on balance an economy of risk under any system of national or world socialism.

§5. _The Entrepreneur_. There remains, however, an aspect of the problem which is perhaps more important than those discussed above. It is probable that risks would be estimated and undertaken more wisely or less wisely under a different system of society or of industrial organization? Upon this issue, methods of precise analysis are out of place, but we may have something to learn from the emphatic testimony of tradition. It has become an axiom of business men that, while Governments can manage with more or less competence a safe and routine business like a Postal Service, their success would be unlikely to prove conspicuous in undertakings where the element of risk is great. There, it is said, we owe everything in the past to the enterprise of individual men (for even joint-stock companies have not been notable as pioneers) adventuring their own fortunes in accordance with their own unfettered judgment. This contention, however much we may desire to qualify it, has unquestionably a large measure of truth, and the explanation is not difficult to discover. For the wise taking of risks in industrial development of an experimental character, peculiar conditions and special qualities are required. First, it is necessary to envisage distinctly the promising though risky opportunity, and this calls not infrequently for imagination of a none too common order. Then it must be studied with insight and expert knowledge and weighed by processes which are as much intuitive as intellectual. The reasons for or against taking a particular business risk are seldom such as can adequately be expressed in terms of arithmetic, or even by clear arguments the soundness of which is proportioned to their logical cogency. The mysterious faculty of judgment enters in; and from mental processes which defy analysis there emerge ultimately conviction and the will to act. But it is precisely here that Government Departments are apt to fail. It is here that the individual, who need consult no one but himself, has a pull over any form of organization, where decisions are reached by the method of debate and agreement among a heterogeneous committee. Hence it is that we have come to regard exceptional risk-taking as the peculiar province of individual enterprise. It is probable that these deficiencies of corporate organization are tending to diminish, and it is an interesting question how far it may be found possible to eliminate them in the future.

Meanwhile the above considerations have an important bearing on the rewards which can often be obtained from risky enterprises. The number of individuals who are in a position to envisage a business opportunity, and to assess with some confidence the chances of success and failure is very limited. Not only must they possess special knowledge, ability, imagination, confidence in their own judgment, and the capacity to act on it; they must also have at their disposal considerable financial resources. To combine all these advantages represents a union of circumstances which is distinctly rare. The fortunate few, who do combine them, are thus generally able to extract in the form of profits a high price for their services, a price which covers not only the strict reward of risk-bearing, and the necessary remuneration of their own service, but a handsome payment for the special qualities and advantages which have been indicated. Profits, moreover, may vary between one industry and another, not only in accordance with the real risk which is entailed, but with the degree to which the supply of special knowledge, etc., is scarce or abundant.

This consideration goes a long way to explain the large fortunes which enterprising business men are often able to amass. It also throws some much-needed light upon the functions which such men discharge. They perform to a large extent the work of management; they supply capital on what may be a considerable scale; but it is the taking of business risk which is perhaps their most characteristic function. It is the union of these functions which distinguishes them as an essentially different type from the salaried manager who has invested his savings in rubber or in oil. In other languages there is a specific name for the man who combines all these three functions; in French he is called an "entrepreneur," in German an "Unternehmer." It is much to be regretted that in English we have no clear corresponding word. The word "capitalist" is not uncommonly employed to do duty in this connection, but this is a source of much confusion. For the word is also used, and more appropriately, to include all investors, whether or not they are active business men.

§6. _Risk-taking and Control_. But there is an allied confusion of more importance. We commonly suppose it to be a leading feature of our present "capitalist system" that the control of industry rests in the hands of those who supply the capital. Nor, as a general statement, is this untrue. But it conceals the essential point. Strictly speaking, it is risk-taking with which control is associated. The mere lending of money carries with it no title to control. Governments and municipalities concede no such title to the subscribers to their loans; nor does a company to its debenture holders. The shareholders' ultimate control is based upon the fact that they bear the financial risks of the concern. Nor is this a matter of mere legal form. It is not uncommon for ordinary shares to carry with them a greater voting power than the preference shares of a corresponding value. The principle which such arrangements endeavor to express is clear: control should rest with him who bears the risk. It is with this principle rather than with a mulish insistence on the rights of property, that advocates of "workers' control" and the like have got to reckon. It is upon this ground that (as they may quite conceivably do) they must make good their case.

§7. _General Analysis of Profits_. Let us conclude this chapter by clearing the ground for the next. Earnings of management, payments for risk-taking and for the special knowledge and advantages associated with it, are ingredients of the gross profits of a business. The chief element that remains is that of interest on capital. Frequently, indeed, it is not the only one. As we saw in the last chapter, a farmer may not be required by his landlord to pay the full economic rent for his farm; and he may therefore make profits above the normal level, above the ordinary return for his own services, his own capital expenditure, and the risks to which he is necessarily exposed. In such a case the farmer is really the recipient, as we have already suggested, of part of the economic rent of the land; and an element of rent accordingly enters into his gross profits. But profits may include a surplus element which may arise in a great variety of other ways. A business may possess some decided advantage which is not open to competitors; and it may reap high profits accordingly. You can, for instance, if you choose, regard the high money profits, which, as was suggested in