There are two points of view from which we may investigate the distribution of income. On the one hand, we may ask why one person has an income of this size and another person an income of that size. In so doing we make use of the popular interpretation of income distribution as a personal distribution of income. But we may also proceed by relating income to the several factors of production and then examining the amount of income accruing to each of these factors (e.g., a capital of $100), without necessarily concerning ourselves with the number of units of such factor (or factors) possessed by the income receiver. Our aim in using this method is to discover what principle determines the amount of wages paid for an hour of work, the amount of rent paid for a unit of land, the amount of interest paid for a capital of $100 (functional distribution of income). As contrasted with this method of inquiry, there is the analysis of the personal distribution of income in which the fact that interests us is that from the several factorial sources of income, individual A receives a total income of $2,000, B an income of $20,000, and C an income of $1,000,000. The principal categories which we establish for a theory of functional income distribution are wages, rent, interest and profits, corresponding to the factors of production labor, land, capital, and entrepreneurship. In this way, we arrive finally at a theory of price formation for the factors of production. Hence, the explanation of the functional distribution of income involves the application of the general principles of price theory. This indeed is the road which the contemporary theory of income distribution has followed.2 Let us leave aside, for a moment, the important questions connected with the personal distribution of income and try to put in relief the essentials of the modern concept of the functional distribution of income.
Once it has been recognized that the problem of distribution is identical with the problem of price, it can no longer be doubted that the distribution of income is an integral part of the entire economic process and that it is subject to the same laws as the other parts of this process. Equally little doubt can be entertained about the essential role played by the price-forming process among the factors of production (into which the distribution of income can be resolved). Where it is desired to ensure the orderly progress of economic life, this process can be ignored neither by our economic system nor by a socialist one. That wages in one country stand at such and such a level, that rents, interest, and profits are of such and such an amount—this is hardly to be ascribed to chance. Rather, these situations are the result of specific economic data. Every attempt to alter such data by force will produce disorder in the economic system which, in turn, will engender still greater counter-forces. That the prices of the factors of production stand at any given moment at a certain level is an essential condition of economic equilibrium, in our system as in any other. He who wishes to change these prices—and what economist would not wish to see rewards to the human factor of production at as high a level as possible-is certainly free to attempt to do so. But instead of trying to acquire the facile reputation of a “social-minded” man by vague demands for a “just wage,” by railing against “interest slavery” and “profiteering,” by emotional outpourings over “gluttonous landlords,” and real estate “speculators,” and instead of shoving aside as “liberalistic” the objections of those who understand something of these matters, one would serve his country better by applying himself to an unprejudiced study of the complex interrelationships of the economy. The insights thus acquired would enable him to discover what the basic factors are upon which it is necessary to act in order to be able to alter the existing distribution successfully, i.e., without provoking a costly disturbance of equilibrium. This is a difficult, thankless, and self-denying task, but one which a genuine social sense and a genuine patriotism oblige us to undertake.
Is it impossible, then, to forcibly raise wages by lowering the return to capital? It is certainly not impossible, but every attempt of this sort leads to a situation which shortly becomes untenable and results in serious disadvantages to the wage receivers themselves. It must be emphasized at the outset that those who promise great things from a transfer of income to the working class are the victims of an optical illusion. Large incomes attract much attention, but most people forget that given the small number of such incomes no particular benefits to the huge number of small income receivers could be expected to result from an equal distribution of the wealth. There would be all the less likelihood of such benefits—and this is the decisive consideration—inasmuch as a forcible transfer of this kind would lead to serious disturbances whose effects would be ultimately borne by the working class. Among the principal disturbances of such a wage policy would be a critical reduction of the economy’s supply of capital and a slowing down of investment activity with its consequent effects on employment opportunities. Capital earnings (interest and dividends) go normally to individuals who spend only a small part of them and return the major share to production as fresh capital. It is very doubtful whether this income, once in the hands of workers, would be saved and invested in the same proportion as previously. To this must be added the fact that a collapse of the securities market, which is to be expected from such a policy, would seriously damage one of the most sensitive and at the same time one of the least understood elements in the complicated apparatus which sees to it that the economy is supplied with sufficient capital and that this capital is rationally allocated. Indeed, a policy of this kind would have a depressing effect on the entire economy and from the interaction of these various causes and effects, depression and unemployment could be expected all along the line. That regard for the economy’s capital requirements and for its investment activity obliges us to set limits to the extent to which wages can be increased, is not a devilish peculiarity of our economic system but—and this is true even of a socialist state—a necessity based on fact. In any case, we have not yet had any information to the effect that the Russian government has fixed wages so high that no surplus funds remain in its hands, nor that this government counts on voluntary savings of the workers for its supply of capital.
Let us take another instance of what happens when wages are increased to a degree which is not justified by the market situation. An arbitrary raising of prices on the labor market will (just as similar arbitrary price rises on other markets) render a part of the “merchandise” unsaleable, i.e., will cause unemployment. If the unemployed are not supported by the state, they will bring their total weight to bear on the wage level (via competition) until an equilibrium situation is again achieved. If, on the other hand, the unemployed are taken care of by the state, their pressure on the wage level will be deflected for the most part. But at the same time there will result such an extreme gap as between the abnormally high wages of those who are employed and the bitter poverty of those condemned to unemployment (not to mention the worsened situation of the tax-paying groups) that we cannot speak of an improvement in the situation of the working class as a whole, but only of an improvement in the situation of one stratum of workers at the expense of the others.
The above picture, of course, has been sketched in broad outline only. In reality, things are, as always, much more complex. Thus, the smaller the forcible increase in wages is, the more prudent and conditional should be our judgment of it. Indeed, there are circumstances under which wage increases may be absorbed without damage to the national economy. We ought also never forget that there is always a degree of “play” between the moving parts of our economic mechanism, making it possible to apply corrective measures without provoking countermovements.3 On the other side, it is also true that the more macroscopic the relationships are, i.e., the greater the amount of force used to alter the wage level, the more inexorably the disturbance to the economy’s equilibrium will claim its revenge. There is a point beyond which a policy of forcible increase of wages may not go without finally provoking inflation and civil war. To deny this is demagogy, which no state, least of all a socialist one, would tolerate.
Or let us take another case in which the interest rate is forcibly lowered. Thorny questions of monetary theory are involved here, and the fabric of interrelationships is even more complicated than that which we observed in connection with our previous example of a forcible alteration of wages. Nevertheless, in this case as in the preceding, there can exist no doubt as to the essential outcome. Here, too, there are likely to be after-effects by which the economic system avenges itself when violence is done to it. In the first place, a reduction in, or even a complete abolition of interest by state decree would probably cause those engaged in capital transactions to find ways of circumventing the control of the state or of the community. In devious ways, an illegal interest rate will establish itself, a rate which will not only correspond to the actual ratio of supply to demand on the capital market but one which will be increased by an amount necessary to meet the costs of more complicated transactions, including an indemnity to cover the extra risks run in transgressing the law. But if we posit the rather unlikely situation where the maximum rate of interest decreed by the state is really enforced, we will find that sooner or later an untenable situation will develop on the capital market. As in every instance where a policy of ceiling prices is enforced, a disproportion between supply and demand will develop. In consequence, the state will be forced to take a further step, viz., to ration the available supplies of credit. This means that the state itself will now take over the functions which hitherto had been exercised by the free formation of interest. Can we assume that it will do the job in a satisfactory manner?
To answer this question, we must keep clearly in mind the fact that the rate of interest of the free capital market is, in the first instance, an appeal to all those who are seeking credit to weigh the urgency of their need by comparing the amount of interest they will have to pay with the profit they may expect from their use of the capital. In this way, interest functions as a mechanism which assures a rational allocation of the normally limited quantity of capital. Let us assume now that this function devolves upon the state. Nothing more efficient or better could happen, many will say. At long last, so they think, capital will be allocated in accordance with the needs of the “national economy.” But when these persons are asked to state their meaning more exactly, they are thrown into the greatest embarrassment. The only certain notion which can be extracted from them is that each would like to see the largest possible amount of this newly cheapened capital allocated to that branch of production which, for material or idealistic reasons, lies closest to his heart. But how will the state and its agencies, confronted by such a multiplicity of wishes, reach a decision? Let us suppose that the state will really seek after an objective norm, and that it will stop its ears against the siren songs of the special interests or of self-styled benefactors of the people, and let us suppose further that the state takes up the concrete question of whether the shoe industry has greater need of capital than the automobile industry. The authorities must obviously begin with the question of how useful the employment of capital in the one and the other industry will be. Now this usefulness, this utility is measurable and comparable only in monetary terms. But this monetary measure is precisely the one which, via the unhindered formation of interest, would distribute the available supplies of capital. In spite of its imperfections and its weaknesses, such a mode of distribution is far more to be relied upon than one based upon arbitrary estimates of the utility of this or that enterprise by state agencies which, moreover, are not liable for the economic losses resulting from a wrong decision, as are the shoe and automobile manufacturers. The case is, of course, relatively simple when it is a question of comparing industries whose employment of capital, in relation to other factors, is in per cent terms the same (capital intensity).4 But it remains a mystery as to how the state will make a rational decision in comparisons involving industries with different degrees of capital intensity. Whether, in a given country, more or less capital-intensive types of production should be favored obviously depends on the amount of capital available in that country as compared with the other factors of production, i.e., land and labor. Here again it is only the free formation of interest, in conjunction with the free formation of the prices of the other factors of production, which can furnish us with a fair degree of reliable information.
Next to wages, rent, and interest, there is still another large and important category of income which can be fitted only with difficulty into the framework of our previous considerations. Let us take the case of an entrepreneur who has entered on his books the costs of the various factors of production, employed under the following headings: wages to the workers, rent to the owner of the land (or to himself as the case may be), interest on capital (also to himself should he have contributed the capital), and a normal rate of compensation for his own services (entrepreneur’s wage). Assume now that our entrepreneur has been able to dispose of his output in such a way that a surplus income remains to him after he has paid for all of the above “costs” of doing business. This surplus we call entrepreneur’s profit, i.e., profit in the narrow and proper meaning of the word. To be sure, this income also arises from the process of price formation since the prices of the saleable output and of the factors of production are the resultants of this process. But it is distinguished from the previously considered types of income in that it represents merely a differential gain and not the market-determined price accruing from the sale of a “service” as it is usually understood. The difficult task of a theory of entrepreneur’s profit is to explain on general grounds the origin of such pure profit, whereby the hardly less frequent case of entrepreneur’s loss (negative pure profit) must also be taken into consideration. Such a theory will also have to answer the question as to whether entrepreneur’s profit fulfills a specific positive function within our economic system or whether it is a simple case of enrichment unrelated to any particular function.
Because of the very nature of the phenomenon to be explained, a satisfactory theory of entrepreneur’s profit must be broad enough to include the manifold sources of such profit (monopoly profits, speculative or cyclical profits, profits resulting from technical or organizational innovations, pressure on wages, payment of risk premiums, profits arising from disturbances in the economic process, etc.). According to the origin of the pure profit in question, it may be judged either positively as a reward for the performance of a useful function or negatively as an enrichment unrelated to any function. There are, however, two considerations of a general nature which need to be emphasized. First, we must not forget that the possibility of the entrepreneur making profits as a reward for efficient service is no less necessary to the functioning of our economic system than the possibility of his suffering losses as punishment for being inefficient. To understand the motive power behind our economic system is also to recognize, in principle, the necessity of entrepreneur’s profit. This point takes on especial significance when it is realized that a healthy rate of investment (which, as will be shown further on, is intimately connected with the economy’s equilibrium) can be expected only if there is the hope of a reasonable profit for the entrepreneur. Denied the possibility of making profits, the entrepreneur would be loath to assume the heavy risks which are invariably associated with the building of a factory, the modernizing of a plant, the expansion of production, the introduction of a technical innovation, even the replacement of machinery. It takes quite a bit of courage to assume such risks in the first place. If we leave to the entrepreneur only his losses and continue to reduce his profits through taxation, wage increases, or other means, private investment activity will be reduced to a game in which one can only lose. The consequence is then stagnation, unemployment, and impoverishment. Secondly, it is to be noted that competition furnishes us with a very efficacious means of eliminating entrepreneur’s profits in cases where they are only a nonfunctional source of enrichment and of reserving such profits for those who perform useful services.5
The masses see only the successful man of business and have but a meager understanding of how such a success is achieved. Equally vague is their knowledge of the silent and pitiless process of elimination which—provided always that competition exists—is carried on among entrepreneurs, a process to which those are sacrificed who are weighed in the scales of the market and found wanting. Thus, the entrepreneur appears in a genuinely competitive market economy as a sort of trustee whom the community has placed in charge of its means of production. Comparing the costs of his services with those of a bureaucratic state-controlled economy, our entrepreneur may be regarded as a very inexpensive public servant, one who really assumes risks, while the politician is apt to be answerable only to God and history. Such a risk-assuming entrepreneur, who disdains the comfortable crutches both of state subventions and of monopoly, should be protected against attacks of a vulgar anticapitalism. From all that we know at present, it is certain that in Communist Russia the differences in income between the economically favored and the workers are far greater than in the capitalist countries, although the population is consoled, from one five-year plan to another, with the promise of a final redemption in which there will be a notable change for the better in its condition. Again, the cliché of the “two hundred families” who are supposed to be secretly exerting an irresponsible control over the free economy’s destiny is, when applied to the entrepreneurs we have described above, thoroughly out of place. The difference between the market economy and the collectivist economy rests precisely in the fact that in the first case economic decisions are distributed among very many “families” which, in turn, are bound by the supreme authority of the market, i.e., in the last analysis by the votes of the consumers. In the collectivist state, on the other hand, these decisions devolve upon a single family—assuming that the dictator has one—against which there is no appeal. These statements are valid, of course, only on the supposition that the entrepreneur does not himself become confused and fall into the defeatism of seeking his salvation under the sheltering roof of monopoly or of the state, forgetting that in so doing he destroys himself.