This section is from the "Elementary Principles of Economics" book, by Richard T. Ely and George Ray Wicker. Also available from Amazon: Elementary Principles Of Economics: Together With A Short Sketch Of Economic History
Under sharp and increasing competition, pure profit rests upon a precarious foundation. If the special ability upon which the profit depends is such as cannot be duplicated, the profit will perish with the single possessor; if the special ability can be duplicated, rival concerns will possess themselves of entrepreneurs of equal efficiency, and the special advantage tends to disappear through competition. But, as we have said, there are certain permanent extra-personal advantages, entirely equivalent otherwise to natural ability, which may become the exclusive and permanent property of a business organization. In case of such possession, competition is either entirely impossible or it is possible only on terms which give to the holder of the monopoly advantage a considerable differential return. Such monopoly advantage exists in the possession of peculiarly favored spots or lines of land, or of exclusive guaranteed privileges, etc. When such an advantage is enjoyed, the power of competition over price is removed; prices no longer stand at the point of cost; and a surplus over rent, wages, interest, and profits i is a regular result. Unless interfered with by legislation, there could be no outside influence to prevent a monopoly asking any price it pleased, subject only to the action of the law of monopoly price which has been explained in the chapter on Monopolies.
Another sharp contrast between pure profits and monopoly gains lies in the fact that whereas pure profit is a surplus produced by superior efficiency, and is in so far no burden to the community, which, indeed, tends to gain by it in the end, monopoly profit, on the other hand, is a surplus extorted by power and privilege, and is usually a source of loss to the community. Distribution of wealth is coming increasingly under the influence of monopoly. The economic surplus taken by monopoly is the source of many of the largest fortunes of our day, and is one of the main causes of the growing inequalities of fortune, especially since our Civil War. While, in general, competition increases in severity, an increasing proportion of the industrial field is withdrawn from competition and falls under the control of monopoly.
Capital and Capitalization. In considering monopoly gains, it is important to understand the distinction between capital and capitalization. Capitalization means the amount at which a business or property is valued. The word is therefore used in the language of the market in two ways. It is sometimes used to describe the par value of the stock and other securities issued by the company, as representing the company's nominal valuation of the business and its earning power. And it is also used to denote the market value of the business or of its securities taken as a whole. Thus a company may be capitalized at $10,000,000 in the sense that its securities have that par value, while the market estimate of the value of the business, as reflected in the prices paid for its securi ties, may be much less or much more than $10,000,000. Capitalization in either of these two senses may be many times the amount of capital actually invested, since it is based not on investment or material cost, but upon earning power.
When we speak of current interest as being 5 per cent, we mean that free and disposable capital can regularly command that rate of return in competitive industry. Let us suppose that the return on investments that are open to all is about 5 per cent, but that the annual return to a great oil company, which has actually invested $100,000,000 in the business, is 50 per cent. The business may in that case be capitalized at $1,000,000,000, in such a way that the great earnings on the actual investment will appear as only 5 per cent on the capitalization. To those who are ignorant of the difference between capital and capitalization, monopolies can often, by such a plan as this, appeal successfully for sympathy and support on the ground of insufficient earnings, even when the return on their actual investment is many times the market rate.
As profits on new investments in competitive industries fall, the capitalization of monopoly earnings may be raised in proportion, even without the investment of new capital. For instance, if a monopoly has an earning power of $50,000 a year, the capitalization of this return at 5 per cent would stand at $1,000,000. If, then, the current rate of interest should fall to 4 per cent, while the monopoly earnings suffered no change, the capitalization of the monopoly, represented by the market value of its securities, would rise to $1,250,000.
And yet it must be remembered that the owners of the stock of monopolistic businesses often include many persons who have paid on the basis of the capitalized value, and who do not therefore receive from the monopoly a greater return than they would receive from investments in competitive industry. It is those who " get in on the ground floor," and who are thus enabled to sell at the capitalized value stock which they have received on the basis of actual investment, who divide among them the capitalized monopoly earnings.
1.The word " profits" as ordinarily used in business often includes many elements of income which are not really profits. The total surplus left in the employer's hands after the payment of contract wages, rent, and interest should be called gross profits.
2.To obtain the net profits of a business there must be subtracted from the gross profits (1) a normal return for the employer's own capital, land, and services, i.e. interest, rent, and wages of superintendence; (2) charges of maintenance, including depreciation and insurance; (3) extra-personal gains, including those arising from monopoly or from chance.
3.The remainder, or the pure net profit, is a differential return due to the superior ability of the entrepreneur, and is in many respects comparable to rent.
4.Pure profits tend to diminish, other things being equal, as education becomes more widely diffused and as industry becomes more completely organized under regular routine.
5.Monopoly profits, on the other hand, have a more permanent character in the absence of government interference.
6.Under the modern conditions of business, monopoly profits are disguised by their form of capitalization.
1. What are gross profits? What is the difference between gross profits and pure profits?
2.Name the deductions that must be made from gross profits to arrive at net profits.
3.What three deductions should be grouped together? What other two groups ? What is the basis of this grouping ?
4.What is meant by wages of superintendence ? Some writers call wages of superintendence marginal profits : explain.
5.What is the depreciation fund? Insurance fund?
6.What are the two classes of extra-personal gains ? What is meant by the word"conjunctural"? Mention instances of conjunctural gains that have fallen under your observation or that you have met with in reading.
7.What caution must be observed in estimating conjunctural profits ?
8.Why are pure profits like rent ? How do pure profits and rent compare as to their tendency to increase or decrease ? What effect does competition have in the long run on pure profits? On monopoly profits?
9.Why is it that monopoly profits often appear to be only equal to the normal interest rate ? What bearing does this have upon popular opinion regarding monopolies?
10.What is the difference between capital and capitalization ? Explain the process of capitalization.
11.What is the effect of a falling interest rate upon the share of the social income that goes to monopolies? Why? What is the effect upon the value of a monopoly privilege ?
12.What bearing has this upon the question of the attitude which the people should assume toward monopolies ?
See note on literature at close of preceding chapter. Also:— Ely, R. T.: Monopolies and Trusts, Ch. III. Jenks, J. W.: The Trust Problem.
Meade, E. S.: Trust Finance. Use Index under " Profits." Report of the United States Industrial Commission, Vol. XIX, pp. 724-730.
Some of the questions treated in this chapter have been the subject of constant discussion in the newspapers and magazines of recent years.