Capital, Interest & Profits
The classical meaning of capital is "wealth that is used in production, including wealth that is in the course of exchange." That seems clear enough at first, but of all the classical definitions, it is the most readily misconstrued. It might be helpful to remember some of the things that capital is not. Capital is not land, because capital is wealth produced by labor; land is not produced by labor. Capital is the material product of labor, not the labor itself — so, it is not any form of service or skill. And — this last one creates great confusion — capital is not money, or stock certificates, or bonds. Those things represent ownership of assets, which could be capital, or could be land, or some form of monopoly.
Another thing that capital is not — in its use here as an economic term — is a class of people in society. It has often been held that the concerns of Labor and Capital are at odds in our "Capitalistic" economy. But that can only be true if we are thinking of Labor and Capital as the opposing forces in the dynamic of Class Struggle. In that scheme of things, "Big-C Capital" is the "ownership class" — which owns not just capital goods, but land as well — and controls the doling-out of privileges.
Different studies define terms differently, to serve various goals. Some consider "Capital" as a socio-political class. Some examine "capital" as any sort of asset that can yield a return. In this course, we're looking at capital as a factor of production. In Henry George's day, the return to this factor was commonly called "Interest." Although many people use this term differently today, in this course we retain the term for the sake of consistency and simplicity. Henry George himself suggested clarifying the term by designating the return to capital as a factor of production "economic interest" — as distinguished from "financial interest," the commonly-used sense of the term.
Is capital, as such, capable of yielding a huge or exploitative income? Let's suppose we've inherited some capital — the rolling stock of a trucking company, say, worth $500,000 — but no land to put it on. What can we do to get an income from it?
We could sell it, deposit the proceeds in a bank, and get a safe (but small) income. If we think we can get a greater income from running the trucks ourselves, we'll keep them. To do that, we've got to haul stuff in them — we've got to use them in actual production. We must rent, or buy, some land to put them on. We must maintain the fleet, or they will soon be worth nothing. We must pay wages to ourselves or to someone else to drive them and service them. If we don't know how to run a trucking company, we could trade the trucks for some form of capital that we do know how to use. But capital in any form must also be maintained — and operated — and located somewhere. How can the ownership of capital per se yield us an exorbitant income? Owning capital sounds more like a headache than a goldmine!
That may be true — but don't we see "capitalists" getting rich in our "capitalistic" economy? Don't we watch wages go down while profits go up?
Profits, in Political Economy
Just what are profits? What is the relationship between profits, wages, interest and rent? First and foremost, we must recognize that while profit is an important consideration for individual investors and entrepreneurs, it has nothing to do with the Laws of Distribution at all. In this course we are concerned with the laws that determine how society's entire wealth output — the "wealth pie" — is distributed among the factors that produce it. In our everyday sense of things, "profit" is an accounting term that simply means a business's income, minus its expenses, during a certain period. That income most likely comes from a combination of all three factors: labor, capital and land.
However, just as we distinguish between the everyday usage and common meanings of economic terms, many economists — and econ textbooks — introduce a concept called "economic profit." Whereas normal, or accounting, profit is the difference between a firm's income and the cost of the factors used in producing it, economic profit is the difference between a firm's income and the cost of the factors it could have chosen — which is called its opportunity cost. Because it involves comparing choices among alternatives, economic profit is seen as a payment for entrepreneurship — economic decision-making and risk-taking. Some go as far as to define Entrepreneurship as a separate factor of production, which earns a factor payment called Profit. Here is an examination of this scheme of definitions in a mainstream "econ" text. (PDF, 2 pages)
Many economists severely underestimate the economic role of land and its rent. As reported in US national income statistics, aggregate rent is less than 2% of national income. If rent is no more than that, then land can be seen as a relatively trivial factor. However, the national income reports use a very narrow definition of "rent," counting only payments to landlords for rented land. The prices paid for land when purchased, or held for collateral, and the share value of corporations based on land holdings indicate a very large proportion of land rent within the distribution of nation's wealth. So where is the rest of it?
Here is where the designation of "economic profit" as the return to "entrepreneurship" can be very useful, politically. It allows the monopoly return from land rent — unearned, by definition — to count as part of the "legitimate" income earned by risk-taking entrepreneurs. Such income is, generally, immune to criticism (and to most taxation), because entrepreneurial innovation is seen as the backbone of the market economy. But, although it is kept well-hidden in conventional textbooks, this conception of rents and profits is fallacious. Rent is either a payment to the passive factor of land or to the active factor of entrepreneurial labor — it can't be both.
We define Land as the passive factor in production: natural opportunities which command an unearned payment, independent of anything their owners do. We define Labor as all human exertion, both physical and mental, in production. So, if people want to think of economic profit as a payment for entrepreneurship, that's fine — as long as they recognize that entrepreneurship is something that is done by labor, the active factor in production. Economic Profit, then, cannot contain Interest, or Rent, or any payment to monopoly or privilege. (And, in our task of analyzing the distribution of wealth in society, we can do just fine without this concept. All it tells us is that "economic profit" — the return to entrepreneurial labor — is a subset of wages, the return to all labor.)
With respect to each other, wages and interest tend toward an equilibrium in which neither factor sustains an advantage. This is because labor and capital need each other in production. Overall production will suffer if shortages of either labor or capital go unmet. However, labor and capital can do nothing without access to land. The utterly key distinction which we must keep in mind is that between land and wealth. When this distinction is lost, as it often is in modern economics, great confusion ensues. For example, if land and capital are considered together, we lose sight of the vital fact that rent varies inversely with interest. That is because the return to capital, like the return to labor, depends on the margin of production. When the opportunity at the margin diminishes, the return to both labor and capital decline, while rent increases.
Here is how Henry George states Ricardo's Law of Rent: "The rent of land is determined by the excess of its produce over that which the same application can secure from the least productive land in use" — or in other words, the margin of production. Thus, the Law of Rent is the basic law of wealth distribution in society.
What Does "The Same Application" Mean?
You might have noticed that the conditions of production at the "margin of cultivation" (simple farming and mining) are very different from those on the most valuable land (what goes on in, say, the Financial District). How can there be any such thing as "same application" of labor and capital"?
It will help to recall that the "same application of capital" is not the same thing as "the application of the same capital." That's because capital is fungible. It can be converted — with the convenient aid of money and banking — into whatever form is called for under particular conditions.
At the frontier, virtually no production is possible without the use of such simple capital as an axe, a shovel or a plow. Having those tools would make an individual's labor hundreds of times more effective than it would be without them! Doesn't that mean that the return to capital is actually much higher at the margin?
At the frontier, land is free, so the worker would use as much land as she could profitably use. But if she has any sense, she won't work that land with her bare hands. She will devote some of her labor to securing the capital she needs to make her labor more productive. Using those tools will make her labor, say, maybe, 1,000% more productive than it would have been without them.
Since capital is so important, won't the owner of capital demand an exorbitant payment for its use? No — because capital isn't a monopoly. If our settler can't get it from one greedy capitalist, she can make it herself, or borrow it from someone else. The capital owner has to decide which would benefit him more: to use the tool himself, or to loan it. If the capitalist decides to loan his capital, he has decided that the wages he'd earn by working in some other way will be higher than what he could earn by using his capital himself. He will be willing to loan out the tool at the general rate of interest.
Why can't he charge more? Well, he could if he had a monopoly — if no other capital were available to do the job. But that would be an extraordinary situation. Capital is produced by labor — and in the real world, suppliers of capital goods compete to get labor to pay for their use.
Perhaps the capital owner could take his capital to the city, and in that highly-productive environment, it would enhance labor's productivity much more than it could at the frontier. Ah, yes, but he would have to pay for land on which to use it — and land in the city is pricey. That is why the laws of distribution tell us that the return to capital at the margin will be the general rate of return to capital everywhere else. Capital may be cast into different forms or put to different uses, in different amounts — but the rate of return to capital will equal the optimal return that it could get where the land is free.
As long as there is any viable opportunity at the margin of production, that is where the return to capital is determined.
And when there is NO viable self-employment opportunity at the margin, do the laws still remain in effect? Indeed they do — but in that case there is one difference. Even if the marginal alternative drops to zero, wages and interest cannot fall that low. Labor has to stay alive, and capital must be maintained in usable condition. So if there is no self-employment opportunity at the margin of production, then wages and interest fall to the lowest level that labor and capital will accept, to get them to come to work.