§1. The New Hypothesis

HITHERTO we have assumed:

• (1) perfect foresight, and
• (2) absence of any opportunity to alter income save by trading.

We now abandon the second of these hypotheses. Still assuming that all available income streams can be definitely foreseen, we now introduce the new hypothesis, much nearer actual life, that the income streams are not rigid, but are flexible, that is, that the owner of any item of capital-wealth or capital property, including, of course and especially, his own person, is not restricted to a sole use to which he may put it, but has open to his choice several possible or alternative uses, each of which will produce a separate optional income stream. He has, therefore, two kinds of choice: first, the choosing one from many optional income streams, and secondly, as under the first approximation, the choosing of the most desirable time shape of his income stream by exchanging present income against future.

The two sorts of choice are exercised concurrently in Edition: current; Page: [126] practice and each in consideration of the other. But, for purposes of exposition, we may take one at a time. Or rather, we may suppose the double choice made and then, in order to analyze it, we go back and consider each process separately, assuming the other constant. Let the varying process be the loan, that is, let us suppose one individual to have irrevocably made his choice from among options mutually available. This done, he is limited, as in the first hypothesis, to buying and selling or borrowing and lending as a means of changing the shape of that particular income stream. In this process he cannot change the present value, but in making his initial choice he had the privilege of selecting that option having the maximum present value.

For example, the owner of a piece of land may use it in any one of several different ways. He may, let us say, use it to grow crops, graze animals, plant forests, extract minerals, or to support buildings. Again, the owner of a building may use it, say, for office purposes, apartments, manufacturing, salesrooms, or a warehouse. Most raw materials, too, may be used for any one of a number of purposes. Iron may be wrought into steel rails, or into machinery, implements, tools, armor for ships, or girders for buildings. And so of tools and other implements; a derrick may be used for quarrying stone, building a house, or unloading a boat. A ship may be used to carry any sort of cargo, and sent over any one of numerous different routes. Hammers, saws, nails, and other tools may be used in almost numberless ways.

Perhaps the most adaptable of all instruments of wealth is man himself. He may be simply a passive enjoyer or "transformer"55 of the services of other wealth Edition: current; Page: [127] and as such derive his satisfactions in any one or more of several different ways, sensual, esthetic, intellectual, or spiritual. Or, he may also be an active producer, and, as such, perform work in any one or more of several different ways, physical or mental. Even the skilled laborer who is most specialized and restricted has many ways to turn. And each of these varieties includes numerous sub-varieties. If his work is physical, it may consist in anything from wielding a pick and shovel to the deft manipulation of the instruments employed in the jeweler's art. If his work is mental, he may be a bookkeeper, clerk, superintendent, manager, director, lawyer, physician, clergyman, editor, teacher, or scientist. Some of these options, of course, may be out of the question and, in each case, there will be only one best choice. That choice is what is now under discussion.

In consequence of such a range of choice, any given productive instrument, or any given set of productive instruments, including human beings, may produce any one of many different income streams. Men may work to produce cheap frame houses or durable stone ones; to equip a city with trolleys, elevated, or under-ground rapid transit; to secure an income stream which shall consist of the pleasures of the table, of the amusements of the theatre, of the gratification of social vanities, or of endless combinations of these groups, as well as of all others. Each individual must select one particular income stream out of a thousand possible income streams differing in size, composition, time shape, and uncertainty; but, in this chapter, the element of uncertainty is, as already stated, supposed absent, being reserved for the third approximation (Chapter IX).

As in the first approximation, a perfect market is Edition: current; Page: [128] assumed in which each individual is so insignificant a part that he acts as if the market rate of interest were fixed and merely has to decide how much at that rate he is willing to borrow or lend.

Because of the existence of a wide range of choice, the owner of a given capital has ample opportunity to modify the income stream he derives from it by changing the uses to which that capital is put. He is seldom so committed to a definite future program but that he can consider some alternative. It is on this principle that the cotton belt of the United States, by diversifying its crops and industries, has increased its real income. The production of these Southern States has recently risen with expanding industries, diversified agriculture, water power development, and improved highways. It was largely by changing the uses to which its income, natural resources, and technological equipment had been put that the South has entered a new era.

Under the first approximation, our first glimpse of any flexibility of income was by borrowing and lending. Next we introduced the process of buying or selling and noted that this really included as a special case borrowing and lending. It might be claimed here that, just as buying and selling virtually include borrowing and lending, so the substitution of one use of a person's capital for another use may be said to include buying and selling, and therefore also to include borrowing and lending. It is evidently quite possible to say that one method of utilizing capital is to sell it. In fact, a merchant regards himself as making use of his stock in trade only in the sense of selling it.

While we could thus extend the meaning of optional uses to include buying and selling (which in turn include Edition: current; Page: [129] borrowing and lending) it will better serve the purpose of our analysis not to do so.

There are two principal reasons for this. First, borrowing and lending, the narrower method of modifying income streams, cannot be applied to society as a whole, since there is no one outside to trade with; and yet society does have opportunities radically to change the character of its income stream by changing the employment of its capital. Secondly, when borrowing and lending, or ordinary buying and selling, are employed to modify an income stream, the present value of the original income stream and the present value of the modified income stream are the same, for each $100 added to this year's income has the same present value as the $100 with interest, returned out of next year's income, so that every loan adds and subtracts equal present values. But when an income stream is modified by a change in the use of capital yielding it, the present value of the alternative, as in the case of the South, may not, and, in general, will not, be the same as the present value of the original. This fact, that the present value is not changed by buying or selling (or, in particular, by borrowing or lending) but is changed by otherwise altering the use of one's capital, marks an important distinction between the two methods of altering one's income stream. The distinction and its importance are most clearly seen by a mathematical analysis such as that shown in Chapter XI and XIII.