Understanding Economics Supplement: Interest & Profits

Capital is wealth that is used in production, or 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 forgotten and misconstrued. It might be helpful to remember some of the things that capital is not. Capital is not money, or stock certificates, or bonds, because those are things that do not directly satisfy desires. It is not land, because land is not produced by labor. It is not any form of service or skill, because capital is the material product of labor, not the labor itself.

It has often been held that the concerns of Labor and Capital are at odds in our "capitalistic" economy. But is it so? Is capital itself 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?

All wealth can be divided into three distinct parts, acording to the functions of the three factors of production. This is what is meant by "functional distribution."
We could sell it, deposit the proceeds in a bank, and get a safe (but small) income. Or we could keep the trucks. But, to get any income from those trucks, we've got to haul stuff in them -- we've got to use them in the actual production of wealth. We must rent 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. Perhaps we don’t know how to run a trucking company, so we can sell the trucks and buy some form of capital that we do know how to use. But it 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 do we not see "capitalists" getting rich in our "capitalistic" economy? We can clearly see wages going down while corporate profits go up!

But just exactly what are profits? And what is the relationship between profits and economic interest? 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.

Profits are the sum of three parts: economic interest (the return to capital), risk premium (and other wages, including "wages of superintendence"), and rent. A great deal of what George refers to as "spurious capital and profits commonly mistaken for interest" is actually income that comes from land. Today, corporate profits include large rents, and can be steady or rising even when the return on capital is falling.

The Dynamics of Wealth Distribution

Land is needed for all production -- and its supply is fixed. Therefore, whenever production increases, demand for the fixed supply of land will increase -- and the proportionate share of wealth taken by landowners will be greater.

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.

One reason why it is so vital to differentiate between profit and interest is that profits contain both rent and interest, and rent varies inversely with interest. If land and capital are considered together, we lose sight of this vital fact! That is because the return to capital, like the return to labor, depends on the margin of production. 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."

"The Same Application?" What Does That Mean?

You might have 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 easily be converted 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 dozens of times more effective! 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?

Nope. 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 out. If the capitalist decides to loan his capital out, 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 for the difference between the two.

Why can't he charge more? Well, he could if he had a monopoly -- if no other capital was 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 viable 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.