The Law Of Interest

The product of the final unit of labor--an amount which in practice is

measured without any tracing of the previous growth of the working

force--sets the standard of the rate of wages. We have now to see that

the rate of interest has a similar basis; and yet it is worth while to

build up, wholly in imagination, a fund of capital, just as we have

made up the force of laborers, increment by increment. This will have

ncidental effect of illustrating another way in which wages may

be determined.

Interest as a Residual Amount

The area BCD in our former figure

represents the difference between the total product of an industry and

the wages paid to laborers. If there is no net profit accruing to the

entrepreneur, this area must represent interest. It is what is left

for the capitalist on the supposition that he and the laborer together

get all that there is. If the goods sell for what they cost, this must

be the fact, and the amount represented by BCD has thus to go to

capital, since, by a rule of exclusion, it cannot go to the

entrepreneur nor to the laborer. The mill and its contents earn for

their operator nothing but simple interest on the money they have

cost. Paying the laborers discharges the first claim on the product,

and there then remains only enough of the product to pay the remaining

claim, that of capital.

The question still remains to be answered, how the capitalist, if he

is a different person from the entrepreneur, or operator of the

mill, can make this functionary pay over to him all that he has in his

hands after paying the wages of labor.

The Importance of the Residuum

The above reasoning does not

satisfactorily show what influence the capitalist can use to make the

entrepreneur pay over to him the entire amount of the residuum. It

shows that after paying wages the entrepreneur will have a certain

amount left, but it is not thus far clear how the capitalist can get

it from him. The fact that the laborers get only the amount

represented by ABDE and that the whole amount is ACDE does,

however, at least show that the entrepreneur has the amount BCD

left in his hands, and that he is able to pay this amount to the

capitalist if by any appeal to competition the capitalist is able to

make him do it.

Interest not determined Residually

The fact is that the interest

on capital is fixed exactly as are the wages of labor.

We will let another figure represent the entire product of the same

amount of labor and the same amount of capital that were represented

in the former case. We will assume that there is at the outset a

complete force of laborers, and that no men are added to it or taken

from it; but we will gradually introduce units of capital instead of

units of labor as in the former case. The amount of capital is now

represented by the line A'E' and the product of the first unit of it

by the line A'C'. The product of the successive units declines along

the curve C'D'. The final unit of capital then brings into existence

the amount of wealth represented by E'D'. As every other unit now

produces the same amount, the capital as a whole creates the quantity

represented by A'B'D'E' and every unit of it makes its own separate

contribution to that amount. In this we have simply applied to capital

and its earnings the principle we formerly applied to labor and its


General Form of the Law of Final Productivity

This principle is

the law of final productivity, one of those universal principles which

govern economic life in all its stages of evolution. Either one of the

two agents of industry, used in increasing quantities in connection

with a fixed amount of the other agent, is subject to a law of

diminishing returns. The final unit of the increasing agent produces

less than did the earlier units in the series. This does not mean that

at any one time one unit produces less than another, for at any one

time all are equally productive. It means that the tenth unit produces

less than the ninth did when there were only nine in use, and that

the ninth unit formerly produced less than the eighth did in that

still earlier stage of the process in which there were only eight in

use, etc. If the productive wealth of the United States were only

five hundred dollars per capita instead of more than twice that

amount, interest would be higher than it is, because the productive

power of every dollar's worth of capital would be more than the

productive power of each dollar's worth is now; and, on the other

hand, if we continue to pile up fortunes, great and small, till there

are in the country two thousand dollars for every man, woman, and

child of the population, interest will fall, because the productive

power of a dollar's worth will become less than it now is.

How Competition fixes Interest

We can now see how it is that the

capitalist can make the entrepreneur pay over to him the amount left

in his hands after paying wages. Every unit of capital that any one

offers for hire has a productive power. It can call into existence a

certain amount of goods. The offer of it to any entrepreneur is

virtually an offer of a fresh supply of the kinds of goods which he is

making for sale. Loaning ten thousand dollars to a woolen manufacturer

is really selling him the amount of cloth that ten thousand dollars

put into his equipment will bring into existence. Loaning a hundred

thousand dollars to the manufacturer of steel, so as to enable him in

some way to perfect his equipment, is virtually selling him the number

of additional tons of steel, ingots, or rails that he can make by

virtue of this accession to his plant.

The Significance of Free Competition

Now, the tender of capital

may be made to any entrepreneur in a particular industry, and the

existence of free competition between these entrepreneurs implies

that a lender of capital can get from one or another of them the whole

value of the product that this capital is able to create. A unit of

capital in the steel business can produce n tons of steel in a year,

and if one employer will not pay the price of n tons for the loan of

it, another will. This, indeed, implies an absolutely free

competition; but that is the condition of the problem we have first to

solve. When we know what ideally active competition will do, we can

measure the effects of the obstructions that, in practice, competition

actually encounters.

Competition for Capital among Different Industries

The capitalist

can invoke the aid of competition outside of the limits of one

particular business. He may offer his loan to steel makers, to woolen

manufacturers, cotton spinners, silk weavers, shoemakers, etc. Within

each one of these industries perfect competition between the different

employers will give him the value of the product which, in that

business, his capital is able to create. If, however, what in this way

he offers to men in one occupation is worth more than what he offers

to men in another line,--if capital is worth more to steel makers than

it is to cotton spinners,--he will find a market for his capital in

the former industry; and this process of seeking out the employment in

which capital is the more productive and there bestowing the loans of

capital, will go on until every such local excess of productive power

is removed and capital can produce as much wealth in one business as

it can in another. Everywhere capital will then be both producing and

receiving the same amount, and general interest will everywhere be

determined by the final productivity principle acting all through the

business world.

When Interest as Directly Determined equals Interest as Residually


The area BCD of the first figure measures what the

entrepreneur has left after paying wages. This amount and no more he

can pay as interest, and he will pay it if he has to. The area

A'B'D'E' of the second figure represents what he must pay as

interest; and we can now see that, if competition is perfectly free,

this amount equals the amount BCD of the first figure. If, after

paying wages, there is any more left in the entrepreneur's hands

than competition compels him to pay out as interest, he is realizing a

net profit; he is selling his goods for more than they cost him, and

this, as we saw at the outset, is a condition that under perfect

competition cannot continue. The natural price of goods is the cost

price. If the market price of anything is in excess of cost,

entrepreneurs receive a profit, and in order to do more business and

make a larger aggregate of such profit they bring new labor and

capital into their industry. The increased output lowers prices, and

the excess of gain is thus taken from the entrepreneur. If BCD is

smaller than A'B'D'E', the entrepreneur incurs a loss and will

curtail his business and let some labor and capital go where they can

produce more.

Taking this remainder of income from the entrepreneur by means of an

addition to the output of goods and a reduction of the price of them

does not annihilate the income, but bestows it on other recipients;

for the reduction in price which destroys an employer's profit can

come only in a way that benefits consumers. It means that enlarged

production of which we have just spoken, which scatters more goods

throughout the community and insures an addition to the real incomes

of both laborers and permanent investors.

Effect of Perfect Mobility of Labor and Capital

Perfect mobility

of labor and capital insures that the residuum in the entrepreneur's

hands after wages are paid shall all be made over to the capitalist.

We encounter here again the static law that, with competition working

without let or hindrance, the entrepreneur as such can keep nothing

for himself; though if he is also a worker he will get wages, and if

he is also a capitalist he will get interest. His business will pay

wages on all kinds of labor, including that of management, and

interest on all capital, including his own. A net gain above all this

it will not afford, and whatever the entrepreneur has left after

paying wages he will have to use in paying interest, and vice versa.

Laborers and owners of capital have, as it were, to take each others'

leavings. Such is the situation in an ideally static condition, though

we shall see how it is changed in actual and progressive society.

The area BCD of the first figure is, under static conditions,

exactly equal to the area A'B'D'E' of the second figure, because

ACDE represents the whole product, BCD in the first figure

represents all that is left of it after wages, measured by ABDE, are

paid; and we know by evidence both theoretical and practical that the

capitalist, whose share is directly expressed by A'B'D'E' of the

second figure, can claim and get the whole of this amount.

Wages as a Residuum

It is clear that the same reasoning applies to

wages. In the second figure they are represented as a residuum. The

area B'C'D' represents what the entrepreneur has left after paying

interest, and nobody can get this amount but the wage earner. The

reason, however, why the wage earner can get it is that free

competition will give him the amount ABDE of the first figure, and

this, under perfectly static conditions, must equal B'C'D' of the

second. Under perfect competition the entrepreneur cannot have any

of the amount B'C'D' left in his hands after meeting the claims that

the wage earner makes on him. On the other hand, he must have enough

left to pay interest, since otherwise he would be incurring a loss,

and that could not fail to force him and others who are in the same

situation to contract their operations or go out of business. If the

output of goods is reduced, either by the retirement of some employers

or the curtailment of product by all, the price of what continues to

be sold will be raised to the point at which wages and interest can be


Wages and Interest both adjusted at Social Margins of


It is to be noted that wages and interest are fixed at

the social margin of production, which means that they equal what

labor and capital respectively can produce by adding themselves to the

forces already at work in the general field of employment. In making

the supposition that, owing to some disturbing fact, a particular

entrepreneur has not enough after paying wages to pay interest, we

assume that the rate of interest is fixed, in this way, in the general

field and not merely in his establishment.

If B'C'D' were larger than ABDE, the entrepreneur would be

selling goods for more than cost and realizing a net profit, which he

cannot do in a static state; but a pure profit is not only possible

but actual in a dynamic state.

In actual business total returns represented by ACDE amount to more

than the sum represented by ABDE (wages) plus A'B'D'E' (interest).

There are conditions that in practical life are continually bringing

this to pass in different lines of business, though not in all of them

at once. The real world is dynamic and therefore the true net profit,

or the share of the entrepreneur in the strict sense of the term, is

a positive quantity. This income is always determined residually. It

is a remainder and nothing else. It is what is left when wages and

interest are paid out of the general product. To the entrepreneur

comes the price of the products that an industry creates. Out of this

he pays wages and interest, and very often he has something remaining.

There is no way of determining this profit except as a remainder. The

return from the sale of the product is a positive amount fixed by the

final utility principle. Wages and interest are positive amounts, and

each of them is fixed by the final productivity principle. The

difference between the first amount and the sum of the two others is

profit, and it is never determined in any other way than by

subtracting outgoes from a gross income. It is the only share in

distribution that is so determined. Entrepreneur's profits and

residual income are synonymous terms. In the static state no such

residual income exists, but from a dynamic society it is never absent.

Every entrepreneur makes some profits or losses, and in society as a

whole the profits greatly predominate.

Summary of Facts concerning a Static Adjustment of Wages

We know

then that in any industry wages and interest absorb the whole product,

because any deviation from that rule in a particular group is

corrected in the way above mentioned. Moreover, general wages and

interest, as determined by the law of final productivity, must equal

those incomes when they are determined residually. The area of the

rectangular portion of one of the foregoing figures must equal the

area of the three-sided part of the other. The question arises why

all entrepreneurs might not get a uniform profit at once. This would

not lure any labor or capital from one group or subgroup to another.

If, after paying wages and interest at market rates, the

entrepreneurs in each industry have anything left, the entire labor

and capital are producing more than they get and there is an

inducement to managers and capitalists to withdraw from their present

employers and become entrepreneurs on their own account. Such an

entrepreneur entering the field, drawing marginal labor and capital

away from the entrepreneurs who are already there and combining them

in a new establishment, can make them produce more than he will have

to pay them and pocket the difference. If such a condition were

realized, there would be a gain in starting new enterprises, since

luring away marginal agents and combining them in new establishments

would always be profitable. When we introduce into the problem dynamic

elements we shall see that centralization, which makes shops larger

instead of smaller, makes industries more productive, and that what

happens when net profits appear is more often the enlarging of one

establishment than the creation of new ones. Entrepreneurs in the

large establishments can afford to resist the effort made by others to

lure away any of the labor or capital which they are employing, and

they will do this for the sake of retaining their profits. They can do

it by bidding against each other, in case any of them are making

additions to their mills or shops, and also by bidding against

any new employers who may appear. Perfect competition requires

that this bidding for labor and capital shall continue up to the

profit-annihilating point. Here, as elsewhere in the purely static

part of the discussion, we have to make assumptions that are

rigorously theoretical and put out of view in a remorseless way

disturbing elements which appear in real life. The static state

requires that all entrepreneurs who survive the sharp tests of

competition should have equally productive establishments, which means

that they should all be able to get the same amount of product from a

given amount of labor and capital. The actual fact is that differences

of productive power still survive. There are some small establishments

which, within the little spheres in which they act, are as productive

as large ones; but there are also some which are struggling hopelessly

against large rivals in the general market and are destined erelong to

give up the contest. In other words, the centralizing and leveling

effects of competition are approximated but never completely realized

in actual life.

A fact that it is well to note is that the test of final productivity

is inaccurately made when unduly large amounts of labor and capital

are made the basis of the measurement. Take away, for instance, a

quarter of the working force, estimate the reduction of the product

which this withdrawal occasions, and attribute this loss entirely to

the labor which has been taken away, and you estimate it too highly.

With so large a section of the labor withdrawn the capital would work

at a disadvantage, and a part of the reduction of the product would be

due to this fact. If we should take away all the labor, the capital

would be completely paralyzed, and the product would become nil. It

would obviously be inaccurate to say that the whole product is

attributable to the labor, on the ground that withdrawing the labor

annihilates it all. With any large part of the labor treated as a

single unit, the loss of product occasioned by a withdrawal of such a

unit is more than can be accurately imputed to it as its specific

product. The smaller the increments or units are made, the less

important is this element of inaccuracy, and it becomes a wholly

negligible quantity when they become very small. A study of the forms

of the productivity curves will show that if we take as the increment

of labor used in making the test only a tenth of the whole force, we

exaggerate the product imputable to it by a very minute fraction, say

by less than a one-hundredth part; and if we take a hundredth of the

labor as a final unit, we exaggerate the product that is solely

attributable to it by an amount so minute that it is of no consequence

in practice or in any theory that tries to be applicable to practice.

A question may be raised as to whether we are correct in saying that

the entrepreneur's profit is residual, in view of the fact that the

entire product of a business is at the mercy of the management, so

that a bad manager may reduce it or a good one may increase it. It may

be further claimed that that part of the management of a business

which consists in making the most far-reaching decisions cannot safely

be intrusted to a salaried superintendent or other paid official and

must get its returns, if at all, in the form of profits. Even in this

case the gains are secured by making the gross return, which is the

minuend in the case, large, leaving the two subtrahends, wages and

interest, unchanged, and thus creating a remainder or residuum. We

shall later see to what extent entrepreneurs do in fact create the

profits that come to them.

The complete static conception of society requires that no

entrepreneur should be left in the field who cannot continue

indefinitely to hold his own against the competition of his rivals,

and this requires essential equality of productive power on the part

of all of them. It is not necessary, however, that all should operate

upon an equal scale of magnitude, for an interesting feature of modern

life is the need of many small productive establishments that cater to

local demands and to wants which, without being local, call for only a

few articles of a kind. Repairs, small orders, and peculiar orders are

executed more cheaply in small establishments, and they survive under

the very rule of essential equality of productive power which static

conditions require. For catering to the general market and producing

staple goods the large establishment has a decisive advantage, and

this insures the centralization which is the marked feature of recent

industrial life.