4.10 Abstinence and time in the theory of profits

If profit were perhaps related to risk, what then accounts for the long-run ‘interest’ component of business profits? The dominant explanation for long-run interest in British economics soon became the abstinence theory of interest.

The first presentation of time as the determinant of interest came from a theory related but superior to abstinence: Samuel Bailey's pioneering time-preference theory. Bailey's discussion came in the course of his brilliant demolition of Ricardo's labour theory of value and his championing of an alternative utility theory. Bailey begins his discussion of time and value by noting that if one commodity takes more time than another for its production, even using the same amount of capital and labour, its value will be greater. While Ricardo admits a problem here, James Mill in his Elements of Political Economy indefatigably asserts that time, being ‘a mere abstract word’, could not possibly add to anything's value.

Rebutting Mill, Bailey points out that ‘every creation of value’ implies a ‘mental operation’ – in short, a subjective analysis of value. Given a particular pleasure, Bailey went on, ‘We generally prefer a present pleasure or enjoyment to a distant one’ – in short, the omnipresent fact of time-preference for human life. Thus:

We are willing, even at some sacrifice of property, to possess ourselves of what would otherwise require time, to procure it, without waiting during the operation... If any article were offered to us, not otherwise attainable, except after the expiration of a year, we should be willing to give something to enter upon present enjoyment.

Considerations of time-discount influence buyers, sellers and capitalists, as well as both parties who realize, for example, that wine gains value by being kept for longer periods of time. Bailey, interested in rebutting labour and other objective theories of value rather than explaining interest per se, did not press on to explain time-preference as the basis of interest nor to discuss the time-discount rate. But his analysis clearly paved the way for the later Austrian time-preference theory, although Böhm-Bawerk, the creator of the theory, remained unaware of Bailey's insights.²⁴

Six years later, G. Poulett Scrope – despite his unfortunate fringe views on Say's law – made an important contribution to profit (or interest) theory, by pioneering an abstinence theory of interest. Writing in the Quarterly Review for January 1831, Scrope deplored the absence of any genuine theory of profit in Ricardo, and proceeded to set forth an abstinence theory.

Despite Böhm-Bawerk's uncharitable strictures on the more highly developed abstinence theory of Nassau Senior, there is not a great deal of difference between the abstinence view and the later, and more sophisticated, Austrian theory of time-preference. Profit, said Scrope, was ‘the compensation for abstinence from immediate gratification’ involved in saving and investing rather than consuming. But Scrope did not stop at outlining an abstinence theory; much of profit, he pointed out, is the narrow form of profit identical with interest. What is vulgarly called ‘profit’, as Scrope called it, is identical with Ellis's ‘gross profit’. This consists, Scrope went on, of interest on capital + insurance against the risks of business + wages for the superintendence labour of the capitalist. Scrope also added monopoly rent, in which he lumped the possession of superior soil or location along with the gains from patented inventions or processes.

But the locus classicus of the abstinence theory was the lectures of Nassau W. Senior. It is true that they were not published until 1836, when they were published as the Outline of the Science of Political Economy (and also as the article on ‘Political Economy’ for the Encyclopedia Metropolitana), but they were delivered earlier as lectures at Oxford in 1827–28.

Senior pointed out that savings and the creation of capital necessarily involve a painful present sacrifice, an abstinence from immediate consumption, which would only be incurred in expectation of an offsetting reward. Unfortunately, Senior lacked the concept of time-preference, so he was fuzzy about the specific motivation that would lead people to prefer present to future consumption. But he came to very similar conclusions, relating the degree of abstinence-pain (or, as the Austrians would later put it, time-preference for the present over the future) to ‘the least civilized’ peoples and the ‘worst educated’ classes, who are generally ‘the most improvident, and consequently the least abstinent’.

Even more interesting and valuable than Senior's abstinence theory was his developed theory of capital, which strongly anticipated the Austrian doctrine. For Senior saw that factors of production could be divided into two classes: the original, primary ones: land (or natural resources) and labour; and all the secondary, intermediate goods which are produced by the joint efforts of the primary factors (as well as pre-existing intermediate factors). Eventually, the intermediate factors are transformed into consumer goods that are able to satisfy the wants of the consumers. It might be thought that ultimately the intermediate factors, or capital goods, might be reduced to nature and labour, but this cannot be done, because another element is needed to combine the primary factors into more and more capital: abstinence. For again anticipating the Austrians, Senior saw that a crucial aspect of this process of production is that it must take time, and therefore an act of abstinence, ‘a term’ added Senior, ‘by which we express the conduct of a person who either abstains..., or designedly prefers the production of remote to that of immediate results’.

Capital, or capital goods, then, taking time, are the result of the combination of land, labour and abstinence, and consists of the application of present resources to future production. Capital goods are produced rather than primary, factors of production. And the way in which production and living standards may increase indefinitely is by using the products of labour and nature, ‘as the means of further Production’. Capital, Senior sums up,

is not a simple productive instrument: it is in most cases the result of all the three productive instruments combined. Some natural agent must have afforded the material, some delay of enjoyment must in general have reserved it from unproductive use, and some labour must in general have been employed to prepare and preserve it.

Senior, then, does not simply have a naive productivity theory of profit or interest. While all factors earn their productivity, and therefore labour earns wages, and land or natural agents earn rent, capital goods are not simple productive agents but complex products of other factors; and so, peeling away the influence of land and labour, the ultimate, distinct productive contribution of capital, is interest – the return to abstinence. While not fully arriving at it, Senior was here groping for a distinction between the gross return of capital goods, whose productivity is reflected in their market prices, and their net return (after deducting from the wages, rents, and prices of other intermediate goods in their production), which equals the rate of interest and is payment for abstinence or time-preference.

In his discussion of how increasing provision of capital funds can allow ever increasing extensions of the division of labour and the production of consumer goods, Nassau Senior captured the essence of the Austrian insight that capital, and eventually production, expands with increased saving because of the superior physical productivity of many longer, or more ‘roundabout’, processes of production. Since it takes more time to invest in these longer processes and intermediate factors, there must be greater willingness to invest in future as opposed to present enjoyment.

Meanwhile, Senior's fellow Whatelyan, Mountifort Longfield, was working along similar lines. Even if capitalists qua capitalists and not as labourers, produce nothing tangible, they perform a vital service in saving capital and paying factors to engage in ‘time-consuming’ processes of production. While most of the British classicists, including Ricardo, spoke perfunctorily of a period of production, they linked it strictly to the one-year harvest cycle in agriculture. Longfield was able to break out of this agricultural framework, moving ‘toward making the time dimension of production a variable in his analysis. He did this by linking the period of production directly to the division of labour and identifying increases in one with extensions of the other’.²⁵

Longfield accomplished this linkage by repeating Adam Smith's famous discussion of the pin factory and the division of labour, while showing that extending that division will bring more roundabout processes into play. In short, greater capital investment will eventually lower the labour time required to produce a unit of output, but only by increasing the waiting time between the initial point of investment and the eventual unit of consumer goods. During the time of waiting for the eventual product, the workers must be able to live, and this living is precisely what the capitalists provide.

They do so by ‘abstaining’ from consumption, thereby allowing the worker to ‘consume something produced by the toil of others, although nothing produced by him has yet been consumed by anyone’. In short, while the product of labour is off in the future, the capitalist saves money now and hires the worker: ‘The person who employs him [the worker] and directs his labour, in general pays him in the first instance, and repays himself by the sale of the articles thus produced.’²⁶ In this way, Longfield was able to offer a remarkable anticipation of the Böhm-Bawerkian theory of capital.

The capitalists' gross profit, then, consists of two parts: a return for the service of advancing wages to the workers until the product is sold (long-run interest), and returns for the labour of direction and for the assumption of business risk. Longfield made no attempt to stress the latter and concentrated on the former, the return for the service of advancing wages. Hence, as Longfield points out in anticipation of the sophisticated and highly perceptive Austrian discounted marginal productivity theory of factor pricing, the worker in effect pays the capitalist a discount from his marginal productivity for the service of supplying money now rather than having to wait for the sale of the product. Again Longfield:

[The capitalist] pays the wages immediately, and in return receives the value of [the worker's] labour, to be disposed of to the best advantage... Hence the value of the labour fixed in... any article, is greater than the wages of that labour. The difference is the profit made by the capitalist for his advances; it is, as it were, the discount which the labourer pays for prompt payment.

It is only a slight step from this analysis to the identification of this discount as a payment for time-preference.

Sir George Ramsay, in his work of 1836, also stressed the importance of time in production and capital, though hardly in as sophisticated a manner as Senior. Time, as well as labour, enters into capital, and Ramsay points as an example to two casks of identical wine. The cask that ages several years longer increases in value, so that value therefore depends not only on labour expended, but also ‘on the length of time during which any portion of the product of that labour has existed as a fixed capital’. Lastly, in 1839, Joseph S. Eisdell, an unknown English follower of Longfield, generalized marginal productivity theory, also noting the important service of the capitalists in serving the worker by ‘advancing his wages immediately on the performance of his work, before the goods are ready for sale, he being too necessitous to wait until the sale, and the receipt of the money for the goods’. Here Eisdell captured the essence of the service the capitalist renders the worker and for which the latter is willing to ‘pay’ the former his discount or profit return: the service of paying the worker now, at present, while the capitalist takes on the burden of waiting for his return until some point in the future.