Risk & Reward

A friend recently asked me how a working individual could free himself from the grind of wage-earning and engage in free enterprise. His argument came down to, "The long and short of it is no matter the theory that everyone can enter the "market" practice is that the vast majority of the population are part of the "cost" of goods and services (labor), with limited ability and opportunity to be anything else."

My response follows.

"So, then, to every man his chance -- to every man, regardless of his birth, his shining golden opportunity -- to every man his right to live, to work, to be himself, to become whatever his manhood and his vision can combine to make him -- this, seeker, is the promise of America."
- Thomas Wolfe

Lets look at free enterprise. Free Enterprise is best characterized as private enterprise conducted by individuals. In most economic circles, the term free enterprise is not often used in reference to corporate activities except in comparison to fully regulated and controlled corporations.

I have been reading Wealth and Democracy by Kevin Phillips and one thing I note is a constant reference to unequal distribution of wealth. This is a somewhat puzzling reference because an equal distribution of wealth is not and never has been a goal of democratic capitalism. He eventually reaches a point where he ties the idea of equal distribution of wealth to the concept that "labor should receive due reward for the value added." The concept that I don't see mentioned is that reward is proportional to risk.

Capitalism maximizes the reward for risk, not for labor. Henry George, in Progress and Poverty states the principle that labor is compensated from profits, not from capital. In a perfect world (Theory, where everything works?), perhaps profits are always guaranteed. In the real world they are not, and that lack of guarantee creates risk.

There are at least two components required for production, Labor and Capital. (George describes Land as a third but we will put that aside for now as for the purposes of this discussion, Land and Capital can be combined.) Labor's contribution to the production process. can be described variously as energy, effort, skill, ability, or talent. Perhaps this can all be summed up as "Work". What is worked on are the resources and materials provided by Capital in the working environment created by Capital.

An individual, working for himself, provides the labor that creates added value, but he also provides the capital which creates the opportunity for labor to do anything. If the product of labor is sold for profit, the laborer is compensated from the profit. If there is no profit, the laborer is not compensated. In other words, the individual who provided all of the components required for production receives all of the rewards.

If several individuals pool their resources to do business in partnership, they may agree that each shares in the profits equally, or they may agree that the individuals share is proportional to their individual contributions. Once again, those that provide the components required for production receive all of the rewards which they share.

The employee-employer relationship is different. Employees are not partners. Employees are paid for their labor, but contrary to Henry George, they are not paid from profits. Employee's wages are paid from capital. Employees, since they are not partners provide no Capital. Employees contribute only Work. In this contribution, the employee assumes no risk. He expects to be paid for his work regardless of the profitability of the enterprise. If not profits, what is the source of the employee's wages but capital?

The entrepreneur puts his wealth at risk as capital in the hope and expectation that the value added by labor which he pays for can be sold for profit in the marketplace. Because the entrepreneur assumes all risk, all the return is his. From this return, he replenishes the capital which he has used to pay for labor and resources and anything remaining is his profit. It is the profit of capital, not of labor.

From this, it can be seen that even in the sole proprietor or partnership, it is the risk of capital that is rewarded, not the effort of labor. Labor without capital has nothing to work on, nothing to which value can be added--nothing ventured, nothing gained.

Most demands by Labor for a "fair share" of profits is specious. To have a fair share of profits, labor must assume a fair share of risk. To assume this risk, the laborer must either provide his own capital (sole proprietor), partner with someone else with an agreement to share the profits (partnership), or purchase shares in a publicly traded corporation (stockholder).

A partnership may be the most promising arrangement from a free enterprise standpoint. In a partnership, a person with skill but no capital can join with a person with capital but no skills and agree to share profits. the sharing can be equal or can be in unequal percentages per agreement.

Otherwise, what the laborer does by becoming a wage-earner is exchange risk for the security of a steady wage. This wage is not paid at the full potential future value of the work he does but is instead paid at a highly discounted rate. The worker surrender his interest in the value created by the combination of labor and capital to his employer who assumes the risk of the marketplace.

What it comes down to is choice. Do you choose risk and the resulting possibility of great reward of great loss, or do you choose the relative security of a steady wage, even though that wage may be less than the full value created by your labor? The choice is different for each of us because each of us have our own needs, desires and responsibilities.

Risk Management

Since the marketplace rewards risk, the more risk, the more reward you can receive. This is good. What is bad, is that the more risk, the more loss you can occur. If you are an entrepreneur, wouldn't it be nice if you could reduce the opportunity of loss without reducing the opportunity for reward? In other words, manage the risk? It seems like a simple idea, and one simple way to achieve this is to lobby government to pass laws and formulate policies that reduce the risk without reducing the rewards. Usually, government's price for this is a share in the rewards because in direct and/or indirect ways, government is sharing the risk. Where this gets out of hand is when lawmakers pocket a share of the rewards and pass the risk on to the taxpayers.

The theory of democratic capitalism combines political freedom with the promise of equal economic opportunity. Economic equality in results is not promised or even implied. Contrast this with communism where political freedom is surrendered in exchange for a promise of economic equality.

Wealth creation is capitalism's strength, and I have seen it said that Capitalism's weakness is that it supports the accumulation of wealth by a small elite group. The accumulation itself is not a weakness. No matter how much wealth the top 1% accumulates, the accumulation does not reduce the access to wealth by the remaining 99%. In a communist economy, wealth is not created by the combination of labor and capital because there is no capital and no free market where price is determined by demand. There is just a relatively static amount of wealth that is redistributed to the workers in a rigidly controlled market. "From each according to his ability, to each according to his need." Production is controlled for the purpose of providing jobs and incomes for all workers, not to supply the demands of the marketplace. As a result, there is no linkage between supply and demand and the result is severe shortages and surpluses--stores full of shoes but no bread.

In a capitalist economy, wealth is created by the combination of labor and capital to produce goods and services sold in a (relatively) free market so anyone that can combine labor and capital has the opportunity to create wealth. This is just about anybody. Opportunity exists to supply the demands of the marketplace. If you can supply a product or service at a lower price and still make a profit, you will be successful. If you can't, you will fail. Unless you can find a way to keep the price high enough to cover your costs or keep your competitor's costs high enough that he can't lower the price. One way of doing this is to lobby government to create conditions in the market that are more favorable to you or less favorable to the competition.

This is the real weakness of capitalism. Instead of large accumulations of wealth, it is the unequal access to political power that large accumulations of wealth can buy. Unfortunately, the type of person that accumulates great wealth is often highly competitive. Highly competitive people play to win and all to often, rules and ethics only apply when they are caught violating them. Quite often, the same competitiveness is found in politics so the combination of business and politics all to often results in some very questionable practices.

What can be done about it? Well, if the public is not aroused, not much. This is a democracy after all and if the people aren't troubled enough to address the situation, who else can? In publicly held corporations which are usually seen as the most blatantly unethical, the capitalists are the stockholders but it is often management that engages in the questionable practices. Just as in government where the voter is ultimately responsible for who is elected to office, the stockholders are responsible for who manages a corporation. And just a most voters pay little attention to politics as long as their basic needs are adequately met, most stockholders pay little attention to management practices as long as they are getting an adequate return on their investment. As in most situations, we have met the enemy and he is us.

As an example of this, consider the recent events at AMR Corp (parent of American Airlines) in which attempts to avoid bankruptcy resulted in the CEO, Donald Carty being forced to resign by the Board of Directors. He had been deceptive in not fully disclosing information to employees being asked to make concessions to reduce costs. What he neglected to disclose was plans for funding a pension plan for senior execs that would be protected in the event of bankruptcy. While asking employees to give up salary and benefits, he appeared to not be asking execs to make similar sacrifices. As a result, he lost the confidence of the employees and the stockholders and lost his job. In his defense, even after it was clear he would have to resign, he worked hard to repair the damage and save the company. He was successful (for the time being) and at least one pilot said he showed more leadership in the last 12 hours than he had in the preceeding 2 years.