171 25 py 1 Business Economics and Statistics George R. Davies, A.M., Ph.D. sLAissmTin ragimnynn Lecture Text Business Economics and Statistics ■ f By George R. Davies, A.M., Ph.D. Assistant Professor of Economics Charge of Instruction in Statistics Princeton University 063(3. NEW York Philadelphia BUSINESS ECONOMICS AND STATISTICS but it has far-reaching practical applications. For unless we can answer it we have little power of forecasting costs and profits; and what is perhaps more important, we have no basis on which to judge what is normal and proper. To answer the question we will do well to try to see the market from the "enterpriser's" point of view. By the enterpriser is meant the one who assumes responsibility and risk in the handling of wealth. To be sure, the term is often little more than an abstraction, for so complicated is the business world that few men assume this function solely. In some degree every active person is an enterpriser selling his services, the uses of his capital, or his goods. He is investing what he has, and is taking the inevitable responsi- bility and risk. But in addition he is also performing other functions. Many men who are enterprisers on a large scale are also managers, and as we have just seen should properly charge off a certain portion of their income to their own time before reckoning what their capital has made. Perhaps in the director of a corporation we may find the function of the enterpriser in its most elementary form, particularly when he turns investigation and man- agement over to paid experts. And in any case we may conveniently per- sonify responsible control of business in the figure-head of the enterpriser, however much the function may in fact be divided. Let us assume the case of the enterpriser of a large industrial cor- poration. He is using his own and associates' property, borrowing funds, hiring labor, purchasing equipment and supplies, and placing goods on the market. Suppose for the sake of argument that business in general is pro- gressing fairly smoothly. Such change as occurs comes gradually, and is anticipated with some degree of accuracy. What now will determine the rent, interest, profits and wages that the enterpriser pays.^ The usual answer to this question is the law of supply and demand. This is quite correct, but it is too broad a generalization to be of much help. We must go further, and inquire into the conditions of supply and demand in each particular case. 4 BUSINESS ECONOMICS AND STATISTICS 2. HOW THE INTEREST RATE IS DETERMINED Let us study, first, the interest rate. When the enterpriser floats bonds, or borrows at the bank for temporary purposes, what rate will he pay? The common answer is that the rate depends upon the amount of money in the country. But this answer is, in the main, wrong. It is one of the fallacies that practical men drop into by judging from a narrow view of the market. It is, of course, true that if a considerable volume of money comes rather suddenly into the banks the interest rate may tempor- arily fall. Such a case may occur when gold comes in from new discoveries, or when large volumes come in from abroad as in 1915 and 1916. The same effect may be produced when for any reason the banks feel safe in expanding their loans as compared with their reserves. Or, in times of dull business, it may occur simply because the money which usually actively circulates through the community is beginning to accumulate at the banks. But a low interest rate thus caused is transient. As soon as the money available for loans begins to be drawn upon, and the money and credit go into active circulation, prices begin to rise. Then larger loans are needed to carry business, and the rate rises. The quantity of money affects prices somewhat permanently, but it affects the interest rate only temporarily in the process of adjusting the price level. In 1920 the money in circulation per capita in the United States had increased sixty-six per cent over what it was in 1910, but the interest rates had risen rather than fallen. The change is shown in more detail in the following table, which shows also the tem- porary lowering of the interest rate that came with the gold importations from Europe in 1915 and 1916. BUSINESS ECONOMICS AND STATISTICS Table I. The Interest Rate in the United States YEAR 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 There are, then, temporary fluctuations in the interest rate that are influenced by the quantity of money. If general prices are abnormally high or low, considering the available quantity of money, interest for a brief time will be correspondingly high or low. And high interest helps to bring prices down to normal, while low interest helps to spur them up, because interest influences the amount of bank credit which is used to sup- plement money. But aside from this matter of adjusting the price level, the real cause of the usual level of the interest rate remains to be discovered. Fortunately, we have not far to look. Any banker will say that in the long run an abundance of capital comes primarily from saving. This is no doubt the explanation of the interest rate as far as the supply of capital is concerned. Of course the amount that may be saved at a given time is limited. The greater part of most incomes is spent for necessities, and is therefore just as much invested as if it were put into bonds, since it serves to maintain the citizenship of a nation. But after all that may liberally be called necessities is paid for, there remains in modern times a large CIRCULATION INTEREST RATES PER CAPITA (prime 60-90 day paper) $34.33 5.0% 34.20 4.0% 34.34 4.8% 34.56 5.7% 34.35 4.9% 35.44 3.4% 39.29 3.5% 45.74 4.8% 50.81 5.9% 54.33 5.4% 57.09 7.4% BUSINESS ECONOMICS AND STATISTICS surplus. This surplus may be insignificant among the poor, but it^aggre- gates a large amount among the middle classes and the well-to-do. The very rich may readily save and invest the larger part of their mcomes. If this surplus is lavished on more or less unnecessary pleasures and dissi- pations, business progress must come to a halt. If it is saved it goes to swell the volume of money and credit available for loans and— other things being equal— helps to keep down the interest rate. That is, the ease with which new capital may be obtained depends upon the general thrift. If everyone should religiously refrain from spending anything exceptmg for the necessities and charities that contribute to his own and the public efficiency, the maximum of thrift would be attained. Thrift, then, makes capital available. But this is, after all, merely one side of the question, and the negative one at that. Before anythmg can be saved it must be produced. Hence the inteUigence, energy and re- sources of a people are the real source of saving. So it happens that, wasteful as the American people are, they nevertheless save more than the thrifty populations abroad. We may at least congratulate ourselves upon our capacity for production, even while acknowledging our short-commgs in respect to thrift. From still another angle the capacity for production is highly important in its effect upon the interest rate. This is from the standpoint of the demand for capital. To see this, let us return to the enterpriser whose point of view we were endeavoring to hold. He and others like him are evidently one side of the loan market which determines the interest rate. The enterpriser voices the demand for capital, while the interest rate is set at the point of equilibrium between the demand and the supply. Now, what will determine how high a rate the enterpriser will be willmg to payr* If he is borrowing for a temporary need, he may perhaps pay an emergency rate which will impair his usual profits, but if this happens he wiU be likely to reduce his operations. Thus he will later be less of a factor in the market. BUSINESS ECONOMICS AND STATISTICS If others do the same as he, the high rate will come down for lack of bor- rowers. Or, we may suppose that the enterpriser is planning to sell long-time bonds in order to obtain funds for the permanent expansion of his plant. Before oJ0Fering the bonds he will sit down and figure out how much of a return on his increased investment he may expect. He will estimate whether the raw materials and labor which are required for the construction of the new buildings and machinery will result eventually in an adequate return. Will the venture pay expenses, depreciation, the interest on the bonds, and a reward for the time and effort of planning .^^ In making his calcula- tions he is directly or indirectly contrasting his own situation with that of other business men who are bidding against him for the use of the public's savings. If he thinks he can make enough to justify paying the rate that others are paying, he will borrow; that is, he will place his bonds on the market. The rate that he can make the money earn is therefore the deter- mining factor of demand in setting the general level of the interest rate. To summarize: The interest rate fluctuates temporarily with changes in the quantity of money and credit in circulation. But in a fundamental sense, the supply of capital is determined by effective thrift, while the demand is principally determined by what the enterpriser can make new capital earn in the expansion of his business. The interest rate at any given time is that which will approximately balance the supply and demand sides of the market. 3. THE TOTAL EARNINGS OF CAPITAL Having stated the law of interest, we may now briefly turn to the two other forms of income going to capital; namely, rent and profits. It will easily be seen that both are of essentially the same nature as interest. In renting property a man expects to get enough to cover its upkeep and the trouble of looking after it, and in addition the usual rate of interest on its capital value. Hence rent expresses approximately an interest yield. BUSINESS ECONOMICS AND STATISTICS But just here the practical man often trips upon a Httle turn of logic that is very important in connection with the evaluation of property. Prop- erty has no intrinsic value apart from, its earnings, on which a rental may be figured. This is particularly true of land, though it is not so true of improvements that may readily be added or removed to other uses. The value of the property as a whole arises from the income that it will produce. If we are sure that a given piece of property will continue to net, say, a thousand dollars a year, then as an investor we might be willing to pay $20,000 for it. In so doing we would be making five per cent on our money. If there was considerable risk connected with the property that could not be readily written off as an insurance expense, then we would probably offer less in order to be assured of a higher rate of return on the investment. But if the risk was negligible and the usual interest ratje low, we might pay $25,000, which would give a yield of four per cent. On the other hand, if the property is likely to deteriorate, as a worked-out mine, a corresponding deduction from its capital value will naturally be made. Mathematically stated, the general rule is that the capitalized value of property is the present worth of the future net returns that are expected to arise from it. Practically the same rule applies to profits. In so far as the net earnings of a corporation can be anticipated, the value of the shares reflects the present worth of these earnings. The owner of the shares usually carries, however, more of the responsibility and risk of the business than the holder of the bond carries. Hence it requires on the average a somewhat higher rate of returns to attract him. But in well established corporations there often comes to be little real distinction between the ownership of shares and bonds. Both represent savings applied to the purchase of incomes. The problem that the enterpriser must meet, of whether he shall further expand his business, suggests another of the fundamental laws of economics. This is the law of diminishing returns. The term when first used was applied principally to agriculture. It was observed that when a farmer increased the amount of capital and labor applied to a given piece BUSINESS ECONOMICS AND STATISTICS of land, that the returns he got for his outlay gradually fell off. When he first doubled his outlay, it was possible that he might on the average double his crop. He might even do better, and get increasing returns. But if he doubled his outlay a second time, it was very unlikely that he would again double his crop. If he increased his outlay ten times, he certainly would not get a ten-fold crop. That is, his returns compared to his outlay would decrease. Later, it was seen that the same law applied in a general way to the profits arising from practically any business, or any industry as a whole. The industry that is expanded beyond the point warranted by the average growth of the country and the condition of the market sooner or later finds its profits dwindling. On the other hand, if it holds back too timidly, it may make a good rate of profits, but yet lose the volume it might have had. Thus the profits that lie just at the "margin '* of expansion — that is, which are next within reach — are the economic signposts pointing to the proper size for an industry. The law of diminishing returns operates in practically the same way for the individual business man or business unit as it does for a whole industry. An enterpriser must find the proper limit suitable to his capacity. He will lose either by undertaking too little or too much. Conditions will vary in different lines. The manufacturer of fine shoes, who must supervise much hand work, cannot profitably handle so large a plant as can the manufacturer of work-shoes, who uses machinery principally. By respond- ing to the law of diminishing returns, or of increasing returns as they may appear at first, businesses and industries grow into a certain relationship to each other, such that the public demand for goods is met in due pro- portions. A very practical side of the law of diminishing returns is seen in the application of statistics. By keeping a statistical check on the growth of various industries, the banks are able to estimate whether credit is being locally over-extended or not. The industries that have the most recklessly 10 BUSINESS ECONOMICS AND STATISTICS expanded under the spur of good times are just the ones that will be hit the hardest when a crisis comes. An adequate statistical knowledge will greatly lessen this danger, and will tend to keep businesses movmg together. The enterpriser, then, has various opportunities of investment into which he may turn the capital under his control. These opportunities tall under the two headings already discussed. First, he may expand his busi- ness temporarily or permanently. In so doing he anticipates a certam rate of profits on which he bases the interest rate which he will be willmg to pay. Naturally, capital devoted to expansion tends to be attracted mto the most profitable available channels. By the law of diminishing returns it there- fore tends to bring down the rate that may be earned on further expansion. On the other hand, new inventions and new avenues of foreign trade are continually opening up increasing returns. Secondly, if expansion is rela- tively uncompromising, the enterpriser may direct capital mto the buying of businesses already established and matured. In so doing he helps to drive up the price of these properties until the rate of yield on the invest- ment becomes unattractive. "Passive investment" of this sort apphes to the stocks and bonds of corporations, to speculation in commodities, and to real estate holdings great and small. Because capital can thus swing from the less promising to the more promising field, the interest, rent and profits rates tend to equalize, though in fact when business is active, m- equalities may be created more rapidly than they can be wiped out Ut course differences in risk are assumed to be allowed for. The average returns on all classes of capital is often spoken of as a prevailing interest rate. Like the sea level from which altitudes are measured, it is a useful figure ot speech, but hard to visualize. Before leaving the subject of the interest rate, one further question remains to be considered. Suppose that over a considerable period ot time the interest rate prevailing in one country is low, while m another remote country it is high. What does this contrast indicate? It is commonly said that it measures the thrift of the people. Low interest seems to indicate 11 BUSINESS ECONOMICS AND STATISTICS an abundant supply of capital, and high interest a scarcity. So the people where the low interest rate prevails are commended for their thrift, and the others are blamed for their sloth. Such a judgment might be merited, but it by no means necessarily is correct. The mere fact that interest is generally high or low gives us no basis for such a judgment. In a new country where the utmost possible economy rules, interest may be high simply because of the abundant profits that arise from expansion. The same may be said of an old country which is being rejuvenated by a series of profitable inventions. On the other hand, a slothful or luxurious people may suffer from a high interest rate because they refuse to save. Again, low interest may be due to lack of opportunity, or the timidity of enter- prisers, and may be accompanied with much luxury spending of the surplus incomes. Hence the interest rate taken alone is no index of the business character of a people. We have seen that the two general factors in production are capital and labor. Capital consists primarily of the land, and the buildings and equipment that have been accumulated upon it. It is expressed as a money value. This value depends upon the incomes that are anticipated from a specific property, and the prevailing interest rate. The term labor covers all valuable effort, from the planning of the manager and the research of the inventor, to the crudest forms of manual work. The value of labor is expressed in the market as a wage, using the term in the broad sense already indicated. The question of what determines wages in an open market will now be considered. 4. WAGES AND THE WAGE LEVEL Like capital investment, labor finds many avenues open to it. The worker, seeking to invest his energies, naturally tends toward the more profitable market, insofar as his aptitudes, likings, and opportunities allow. But the movement of labor from one occupation to another is strictly limited by habit, and by the difficulties of mastering a new technique. 12 BUSINESS ECONOMICS AND STATISTICS So the process of equalizing wages in proportion to service is slow. In the professions it is gradually brought about by the influx of new recruits into the better paying fields. In the semi-skilled occupations, however, there is considerable shifting of labor from one line to another. In occupations of about the same grade, wages are thus approximately equalized. If all men had equal ability and opportunity, wages in all occupations would tend to an equality. Only minor features of agreeableness or dis- agreeableness would give a basis for any permanent difference. But in fact wages are naturally very unequal because of inherent differences in ability. Differences in opportunity also play a large part, but even if these were equalized, important wage contrasts would still be based on natural differences. Genius is extremely rare, talent is scarce, moderate capacity is abundant, while fortunately real incapacity is scarce. It is true that genius does not always bring its proper reward, because the market sometimes fails to appreciate it. But the talent of the professional classes commands a high return because it is both serviceable and scarce. Just as there is a prevailing interest rate, so there may be said to be a prevailing wage rate. This prevailing rate is most readily measured on the basis of common labor. But what is true of common labor, will under modern conditions generally be true of the higher grades of labor as well. Men rise from the lower to the higher ranks, and so moderate the extremes. If salaries are high, common wages will also be proportionately high. Thus the high managerial salaries in the United States are paralleled by the high rate for common labor. The level of common wages may therefore be taken as a base line by which to compare general wages in different countries, or at different times. The wage level is determined in somewhat the same way as the interest level. Enterprisers in operating and expanding their properties bid for labor. When business is active, they are likely to employ all who are employ- able, and to seek to obtain more by immigration. It is to their interest to 13 BUSINESS ECONOMICS AND STATISTICS keep practically all the labor force employed in order to attain maximum production and profits. But at times they may over-do their competitive bidding for labor, and send wages above their normal level. When this occurs, business becomes less profitable, and therefore slackens. Hence the volume of business will tend to conform closely to the limits of the labor force, though fluctuating above and below these limits. The size of the wage will evidently be limited by the productivity of labor. The economist would say the "marginal productivity," since it is the results obtained by adding to the labor force that serve as the practical measure of productivity. As long as enterprisers are able to make more than normal profits by adding to their labor force, they will be actively in the labor market. When an increase in the number of workers employed brings in no returns above the added wage cost, further employment will stop. At this point, more or less accurately estimated, equilibrium is reached. The demand for labor, then, expresses itself principally through the bidding of the enterpriser. His capacity for bidding is the productivity of his business. A country with rich natural resources, able enterprisers, and industrious and capable workers, will bid stronglj^ for labor. The supply of labor is the aggregate of services sold by the working population. This, in general, is proportionate to numbers. Wages are set by the usual equili- brium between demand and supply. This does not contradict the previous statement that the marginal productivity of the laborer sets the wage, since the marginal productivity responds to the supply in accordance with the law of diminishing returns, and is the basis of effective demand. Since supply and demand rule in the labor market, it is often thought that a considerable lessening of the labor supply will raise wages. This is not necessarily the case. It is true that a sudden shortage of labor may temporarily send up wages, but if the shortage is permanent, some busi- nesses will close and the labor demand will diminish. It is evident that an extremely sparse population in a fertile country is not favorable to high wages, since division of labor then becomes difficult. The immigration 14 BUSINESS ECONOMICS AND STATISTICS into America during the past century probably did not lower wages except locally and temporarily. On the contrary, it probably raised wages by making possible the diversified industries which now create the demand for labor. But after the point is past where the numbers of the population are suitably proportioned to the available resources, then further additions to the labor supply will lower wages. The former conditions give increasing returns; the latter decreasing returns. In view of the fact that population is continually increasing, the extreme importance of progress in business becomes evident. When adequate progress is maintained, enterprisers will have increasing incomes at their command with which to bid for labor. Using better machines and pro- cesses, labor will be more productive. Though some loss may be occasioned by the necessity of learning new methods of work, yet wages will be con- stantly rising. But if surplus wealth is squandered in luxurious living, new capital will be lacking, and progress may fail to keep abreast of popu- lation. Wages will then fall. More than a century ago a famous economist predicted that popula- tion would always increase so fast that wages would be driven down to the point of bare subsistence. Thus far his prediction has not proved true, nore does it seem likely to come true in the immediate future. It is true that population has increased with great rapidity during the past century, but production has increased still more rapidly. The estimates given in the following table show this fact for the United States during the past few decades. Table II. The Production of Wealth in the United States DECADE 1870-1880 population [millions] 44 production AT 1913 prices I billions of dollars] 8 PER CAPITA PRODUCTION {^180 1880-1890 56 12 210 1890-1900 69 17 240 1900-1910 84 25 295 1910-1920 100 35 350 15 BUSINESS ECONOMICS AND STATISTICS From this table it appears that per capita production or income, as measured in constant prices, has ahnost doubled in forty years, and is still increasing.* It may be shown that wages have increased about as rapidly, though not so evenly. In estimating wages, allowance must of course be made for price changes. This may be done by dividing an average of com- mon wages for any given year by the average of prices for the same year. Data are furnished by the Bureau of Labor Statistics from which such an estimate may be made. The results are called "real wages" to distinguish them from the wages as paid in current prices. For comparison it is found more convenient to express real wages in percentages of the year from which prices are reckoned. The base year now commonly chosen is 1913. Thus expressed, the index of real wages in the United States appears as fol- lows: Table III. Real Wages in the United States INDEX OF YEAR REAL WAGES 1870 48 1875 54 1880 56 1885 76 1890 85 1895 97 1900 91 1905 96 1910 94 1915 102 These figures show that real wages rose very rapidly up to 1895, but that since then they have not advanced much. Some such results might * American industry probably leads the world in per capita production. Even before the war British incomes averages only about seventy per cent of American, and a certain part of that was from foreign investments. 16 BUSINESS ECONOMICS AND STATISTICS be expected, since by the end of the nineteenth century population had about caught up with the rapid industrial advance. The volume of capital used was greatly increasing, and land values were advancing as a result of the relative closing of the frontiers. But the slackening of advance in common wages is compensated for by the widening opportunities in the skilled occupations and the professions. The movement of wages and prices during and since the war is of interest, and is valuable as throwing light on the responsiveness of the labor market. It is often said that wages are stabilized by custom, and that therefore they move much more slowly than prices. This may have been very true in former days. It may also be true today of certain occu- pations, such as the postal service, teaching and preaching. But it is not so true of industrial wages, under present conditions. A considerable portion of the labor army is mobile, and quickly moves to the point of greatest demand. Union activities also tend to push wages up whenever the condition of the market makes it possible. Therefore the market for labor is coming to be almost as responsive as for commodities. At least, such is the conclusion that is suggested by a review of the figures for the last few years. The following table gives indexes for prices, and for labor of specified kinds. Table IV. Prices and Wages in the United States Since 1913 WHOLESALE cost of WAGES HARVEST UNION RATE XEAR PRICES LIVING* (hour rates) HANDS (minimum) 1913 100 100 100 100 100 1914 100 100 102 98 102 1915 101 101 103 99 102 1916 124 108 111 107 106 1917 176 133 128 131 112 1918 196 155 162 166 130 1919 212 184 197* 197 148 1920 243 212 222* 225 189 Annual indices estimated from seasonal data. Source, Bureau of Labor Statistics. 17 BUSINESS ECONOMICS AND STATISTICS Z80 Z60 ft4C 180 /60 /40 i20 too /fj dices ofr/a^es anci CosT of Liy//f§^ /9/i-'/920 jy/a^e