HG8790 1)24 i Cornell University Library HG 8790.D24 Capitalization and market value, 3 1924 013 998 657 New York State College of Agriculture At Cornell University Ithaca, N. Y. Library aPITALIZATION AND MARKET VALUE ■!4' I (II ' ij ,1 1 •'! I '■I ' 'l( I'l i|f.f.. i ||fi!!l'l|!|K; A PAPBR BY H. J. DAVENPORT JU Diversity of Missouri [From the Vale Review, August, igio] Yale Publishing AssoctATiON, 135 Elm Street, New Hslven, Conn. Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013998657 CAPITALIZATION AND MARKET VALUE A PAPER BY H. J. DAVENPORT University of Missouri [From the Yale Review, August, 1910.] Yale Publishing Association, 135 Elm Street, New Haven, Conn. CAPITALIZATION AND MARKET VALUE. CONTENTS. The Arithmetical Doctrine of Capitalization stated, p. 132 ; difficulties in applying it, p. 133 ; the adjustment of market price is the same for produc- tion as for consumption goods, p. 136; demand not homogeneous, p. 137; capitalizing rates of interest not homogeneous, p. 139 ; the prevailing doc- trine implies a social organism which is inconsistent with individual dififer- ences, p. 141. AS an arithmetical formulation it may be safely said that the present worth of any future income is that number of dollars which put at interest at the assumed rate will give the same amoimt. To find, therefore, the present worth of a sum of money definite in amount, free from hazard of non- payment, and due at a fixed time, is not difficult, provided only that a rate of interest is assimied for the case. But have we not to do here solely with arithmetical processes rather than with economic doctrines — precisely as when we assume a certain rate of multiplication for sheep or mice, and set ourselves to compute the present stock adequate to promise a certain future total in a given time, we may regard ourselves as steadfast on the high table-lands of mathematical truth untempted to the lower levels of zoological or biological science? But as our formulations become more and more questionable, they are presumably on the way toward a more distinctly scien- tific^ character , and standing. Thus we learn from economic theory that the Value of any instrument of production is derived from its prospective incomes, through the discount of these to a present wtrth under a given rate of interest; but we are at the same tiiiae assured that these earning powers themselves determine their own rate of discount. And we are further told, on like auth6rity, that the values of productive instruments are determined by their costs of production instead of by the capital- ization process. , igio] Capitalization and Market Value. 133 But if we are content to regard this capitalization doctrine as acceptable and to follow it in perfect trust, how far is it likely to lead us ? Whether the productive powers of land have themselves any part in fixing the interest rate upon which the capitalized value depends, we may never be indubitably told; but we are assured that knowing the rent of the land, we arrive at the value by discounting the series of rents into one total of present worth under a market rate of interest somewhere and somehow fixed. The determination of the total present worth of any kind of annuity, temporary or permanent, is typically of this sort both in principle and in process; and all durable sources of income are, eo nomine, annuity bearers for the term of their service; all, therefore, receive their market value through the discount process. And all durable consumption goods are likewise, for the purposes of this problem, income-rendering, since they afford a succession of valued services. As with other incomes, so with these. Future revenues suffer, as rendered over into a present estimation, by the very fact of this remoteness. Thus the discount rate presents itself as fundamental to the determi- nation of the value of every item of durable wealth. Similarly for wages. Wages are a derivative or a' distributive share out of a value product; they must then suffer a discount in the degree that the wage precedes in time the marketing of the product. The capitalization doctrine means, therefore, that the interest rate takes some part, more or less controlling, in the determination of practically all market values. All this seems to say that for all goods, whether of the pro- duction or of the consumption sort, the rate of interest is funda- mental to the process of valuation, if the services are in any degree remote in time. Precisely how wide an area the psycho- logical present covers — how remote, that is, an item of service or income must be in order that it suffer in present value by reason of this fact of remoteness — may be diificult of definite formulation; but this in nowise disturbs the proposition that remoteness in time is everywhere an influence to lower present value. 134 Yale Review. [Aug. Nor is this the full reach and meaning of the capitalization doctrine as we seem to meet it : if certain issues of stock appear to promise an increase in dividends, this larger promise is forth- with reflected in present market quotations. Likewise, if tax- ation cuts into net earnings or net rentals or net interest, there follows a proportionate fall in the market price of stocks or lands or bonds. And so, in general, if the market rate of interest falls, the prices of all durable sources of money income or of valuable utility forthwith advance to correspond. Thus the market rate of interest stands as the master key for the unlocking of most problems of market valuation. Surely this a simplifying of things even up to the point of bewilderment. Can all these things be indeed after these ways ? For notice again that, after all, this capitalization doctrine rests on the assumption of a fixed and definite annual rental and of a fixed and definite market rate of interest. And yet it is hardly credible that before there was an established medium of exchange, or an organized credit system, or any considerable credit of any kind, or any market rate of interest, there were no exchange relations upon instruments of production and upon durable consumption goods. Nor can it be true that these rentals, in the sense of established market values, upon the temporary use of instruments and of goods, must have established themselves before any market value became possible for the goods themselves. Were each man owner and user of his own houses and of his own land and of his own cattle, would market values now be impossible of establishment? But there are further difficulties : Those rents awaiting capitalization are themselves distributive shares out of the joint product of the various factors of production. The product, in turn, may itself be a long-time instrumental good or a long-time consumption good ; as such it assumes an existing rate of inter- est in order that it may take on a present market value. But otherwise than with a present market value there is nothing to distribute. Moreover, we now recall that those rents, sO' derived from the value product, themselves determine the rate of interest by virtue of which a value product comes to exist. We seem then to be driven to the conclusion that an interest rate exists igio] Capitalization and Market Value. 135 independently of the productive process, and independ- ently of the rents derivative from it: Otherwise how- could the product receive a valuation ? And without a valuation what was there to distribute? It thus appears that this attempt to deduce interest rates from rents hides its own undoing; the productivity theory of interest ushers itself out of the door. Political economy appears to need an interest rate ready made to its hand : all our analyses begin and end in this interest assumption : on any other terms our case will not get on. But if fear should arise that upon this showing the interest rate may be in danger of breakdown from overwork, this anxiety may be promptly dismissed. On this showing there can never be any interest rate at all. For there are other difficulties. Since there can be no value product without a preexisting inter- est rate, it forthwith becomes impossible to have an original value contribution upon which to compute a value surplus. And precisely as there can be no value product without a preexist- ing interest rate, so there can be no preexisting rate without a preexisting value product. The entire adventure goes into bankruptcy — shutters down, lights out, doors locked. But one at least of our difficulties may be easily set aside. There is in fact no fundamental contradiction in explaining the value of a production good either from its past, its cost, or from its future, its earnings. In any view of the case, cost can bear upon value only as it bears upon the supply side of the value equation. Lower costs imply an increase in the supply of the production good, forthwith an increase in the consumable pro- ducts, thereupon a fall in their price, and therefrom a lower rent to the production good. Thus an increase in the supply of the production good lowers the rent of it. It has now become logically open to appeal to the capitalization of this rent to arrive at the market value of the productive instrument. There is here no denial of the determination of value by cost; cost still stands as ultimately the determinant of value — the demand being assumed — since by regulating supply the cost determines the rent. Obviously, however, the fundamental dif- ficulty in the capitalization problem is not here ; it lies rather in 136 Yale Review. [Aug. the problem whether for arriving at a market value there need be either a market rent or a market rate of interest. But surely there is some soul of truth at the heart of this capitalization doctrine. If grapes could really be gathered of thorns or figs of thistles, thorns and thistles would then be some- thing other than thorns and thistles. Not earning dividends, stocks likewise would lose their value. It is the putative future wool from the sheep or the forecasted hay from the meadow that gives to the present possession significance, motivates the price-sacrificing disposition of purchasers, and thus lies back of the present market value. And — at least in some large general way — it is true that, as the wool turns out to be more or better as a value item, or the crop more generous, the market value is greater for the product-bearer. And somehow, also — ^whether as ultimate cause or not — market values do rise, even though the annual return is unchanged, if only interest rates are falling. Nor need it greatly matter for the present purpose that no par- ticular one of all the various rates of interest — ^the bank rate, the call rate, the government rate, the savings bank rate, the average rate — seems to have any especial claim to be regarded as peculiarly and exclusively the capitalizing rate. But it is after all clear that the process of market adjustment of price is one and the same process for all goods appearing upon the market. It is not true that the method is one method for the farm or the traction engine or the draft horse, and another, and a fundamentally different method, for a bushel of wheat or a pound of candy. In the case of a stock of con- siunption goods of substantially similar quality, the legendary hats for example, the conventional analysis has become weari- somely familiar. We all know that in cases of this sort some men will offer more and others less, and that with each different man the price-paying disposition falls with each change in his achieved or contemplated purchases. As the summation of all these individual price-demand curves, we have an aggregate demand schedule — the curve of market demand. The price at which the whole demand is adjusted as against the whole supply igio] Capitalization and Market Value. 137 coincides with the price-paying disposition of few of the pur- chasers, and need not precisely coincide with any. There are buyers' surpluses, great or smaller, even sometimes for the weakest purchaser. This is all as simple as it is tedious. But because there is only one process for both consumption goods and production goods, there are some things implied in this analysis that demand clear and definite acceptance. There is here no vaguest hint that any social organism is mysteriously and spookily present; the fact is simply that they are just different men trying competitively to buy things from other men who are trying competitively to sell things. And while no doubt is suggested that each buyer is try- ing to get something useful to himself, there is no slightest intimation of any large general social utility in the background. In point of fact, no one man's utility is homogeneous with that of any other man — even with two men disposed to pay the same price for the final unit. There is neither homogeneity nor equality of utility implied; one man may be a rich man, the other poor — or both may be equally poor but unequally hungry. And even could equal paying dispositions infer either equality or homogeneity of service, the paying dispositions upon the market are in fact not equal ; it is precisely for the purpose of express- ing and asserting this fact of inequality that we construct our demand schedules or curves. A marginal price offer — if accu- rately marginal — expresses merely the equality of service between the thing in prospect and some other thing to be had for the same money. Marginality, that is to say, is an attitude of indifference between two competing applications of purchas- ing power — an equality ratio between utilities, without sugges- tion as to the size of either, and with still less suggestion of homogeneity with the utilities of anyone else. And here is the important application for our present prob- lem: Precisely as there is no homogeneity of service suggested in the demand curve for wheat or for hats, and as even an equal- ity of price-paying disposition is expressly denied, just so there is neither homogeneity of significance nor equality of earning power implied in the demands of various farmers for plows. 138 Va/e Review. [Aug, The one thing common to all these different offers is that they are offers of money; and all of these offers of money differ in the size of the offer. The market outcome that results attrib- utes, therefore, no specific productive power to plows, but is merely the attaching to them of a market value — a market value based no doubt upon the fact that plows are capable of being used by these different men as an aid to each one in his process of production — but as an aid in differing degrees. It is pre- cisely because the entrepreneurs are different that there must be as many different productivenesses of plows as there are dif- ferent men. There is no one real and ultimate and specific productiveness. The very differences in price-paying disposition which the demand schedule presents should alone suffice to prove this. Market price is not a statement of what the productive- ness specifically is, but expresses only the market value of the productivity. It follows, therefore, that there is no one income- earning power for any one productive instrument or grade or kind of instrument, which definite income-earning power may thereupon be capitalized into a market value. Such ascription of productivity as takes place is a purely personal appraisal, and this appraisal is a process preceding the price offer of each individual bidder and leading up to it. The market price which results is, therefore, merely the outcome of a process of adjust- ment between the total supply of goods on the one side and all the different price offers on the other side. Each and all of these various price offers are influences in the case. The market price is merely the equilibrium point, and is not a pronouncement in the favor of the correctness of any one out of all these various appraisals. Nor is it, in any sense, the declaration of any social or general or specific productivity for plows in general or for any item of the genus plow. Even more conclusive is this analysis as it applies to cases of goods not present in stocks. That price which must be paid by the successful bidder for any particular farm is the price necessary to exclude the strongest competing bidder — if indeed there is a competitor. If there is none, the lower limit upon the price is found in the reservation price of the seller. Thus iQio] Capitalization and Market Value. 139 the actual price is commonly appreciably lower than the possible upper limit. The margin for higgling, the interval for possible traders' surpluses, is a passably wide one in the ordinary case. The maximum bid of the buyer is doubtless based upon the productivity relation of the farm to him. But there is nothing here to suggest the derivation of his bid from the process of capitalizing some market rental or market appraisal of this pro- ductivity. The only thing that the market specifically declares is the market price of the farm. There need be no market rate of rental nor is there any chain of causal sequence here in which any market rental can form a link. Nor even where the thing to be marketed is a fixed and definite annuity — a government bond, for example, or a ground rent — does a different line of reasoning apply. Different bidders place different personal estimates upon the degree of hazard, and vary in their degree of reluctance to assume the hazard, and vary as well in their financial ability to carry the hazard. Translated into a personal price appraisal, the different bids must vary as the bidders are various. And even where an invest- ment may be taken to be free from all necessity of supervision or care, and to be clear of all taint of uncertainty, it must remain true that different investors attach all grades of importance to this question of safety. Guardians and trustees bid par of 2 per cent, securities. Some investments carry with them variously estimated advantages — for example, the political lever- age and social prestige of land — and must, therefore, suffer in their rate of purely monetary returns. Enough has perhaps been said to the point that market rents do not get capitalized upon the market, but rather that personal rents get capitalized into a personal price offer. It remains to show the parallel truth that no one of all the market rates of interest is the capitalizing rate. Nor is there any one market rate having direct reference to the case. Those interest rates that bear upon market price must be those rates which are behind the different price offers that together make up the demand schedule. These rates are not one but many; they are the purely personal rates of the different men whe are deciding 140 Yale Review. [Aug. what present offers they shall respectively make. Thus the differ- ent rates are as many as are the different men. What any man's funds are worth to him in other lines of activity must commonly determine the rate upon the basis of which he can afford to bid for any given item of investment. If, in view of his limited credit and of the needs of his business, it will cost him 10 per cent, to direct his resources toward the purchase of a traction engine, then 10 per cent, must be his discount rate. The rate for the sort of man he is, in view of his line of business and of his peculiar circumstances — ^that is, the rate at which he must borrow upon the market if he can and does borrow — will be one out of the many influences concurring to determine his personal interest rate. Under this purely personal rate he will discount into a personal price offer the particular future rental or earning advantages which the good in question appears to promise to him. He may well decide not to invest $1,000 in an improvement which would earn him a net annual advantage of $200, and it is not decisive, or even necessarily relevant, that money can be borrowed at 5 per cent, by other men. Another man may see in this improvement only one-half as great an annual service to him, and may nevertheless wisely undertake the outlay; this will depend upon what his funds are worth to him. It is clear, then, that each individual man must have his own rental estimates and his own private rate of interest before he has before him the data for arriving at his own offer price. Market values are not accurately to be stated as deri'\'ed from future market rentals discounted into a present worth under a market rate of interest. Durable consumption goods offer, however, the more telling illustrations of the correct principle. A piano may offer not only a far greater monthly service to the less wealthy man than to the more wealthy, but a service for which the less wealthy man would consent to pay the greater monthly charge; but in determining which will buy and which will go without the piano, or which would prevail in competitive bidding, the lower per- sonal discount rate of the rich man may well overbalance the higher rents to the poor man. The latter may, for example, igio] Capitalization and Market Value. 141 severely need to repair or to enlarge his house. The same anal- ysis explains why the well-to-do choose to keep themselves warm in well-constructed buildings with expensive heating plants, while the poor accept a larger expenditure of coal to be consumed in defective heating appliances. Were it to the present purpose, the tenability of the notion of specific value productivity could well be subjected to further scrutiny. It would then appear that the outlay which any entrepreneur can afford to make, as the annual hire for any particular instrument good or as the total purchase price of the good, is not the money equivalent to him of the specific productivity of the instrument, but merely the money equivalent of the added income which his present productive equipment and this addition will together achieve, over and above what could be achieved without the addition. This addi- tional income is due in part to the independent productivity — if there be any — which the new fact bears in its own right, in part to its added productivity in its new setting, in part, also, to the added productivity which the old facts take on in their new association and relation. So far as the productivity is a matter of the interrelations of the different parts of the entre- preneur complex — the entrepreneur himself being a part thereof — and a matter of the organization of the complex, there is a productivity which defies any attempt at distribution. This, however, is not at all to deny that the entrepreneur knows how^ much he would if necessary pay as a maximum in order to com- mand the added item of equipment. The truth is that the prevailing capitalization doctrine as an explanation of the value of durable goods — like the old pain cost explanation of value and like the new marginal utility explanation — has no other logical basis than the assumption that there exists a social organism, and is intelligible only when interpreted as part and parcel of the social organism theory. Much indeed that is actually not tenable in economic analysis would be tenable if only this doctrine of the social organism could be made to hold. On these terms a social valuation could 142 Yale Review. [Aug. take place; so the doctrine of specific productivity might pos- sibly command acceptance, and to the extent that we are able to peer into the mystery, we may well believe that there would be a social perspective between present and future goods, and a social comparison between present purchasing power and future purchasing power. And thereupon, by the aid of its social rate of discount, society might proceed to discount the future specific productivities into present market prices. And accomplishing thus much, the social organism doctrine would have a long series of achievements to its credit. But even so, the attendant perplexities might more than overbalance the account, for what should we do with the new worries prompt to hag-ride us? For admit it to be true that production is not individual but social, and market value social; it nevertheless stands firm that consumption, and the distribution upon which consumption depends, are individual. But these incomes of rent, interest, wages and profits, as individual and distributed shares to their recipients, are at the same time costs of production to the entrepreneur. As costs they may in some sort rank as determinants of that very value which we seem to have agreed to regard as purely social. And is the entrepreneur to be conceived as a social entrepreneur or as an individual entrepre- neur? — and is profit a social or an individual profit? Does it matter that part of this profit is unnecessary, is an excess above the social cost? Or are we somehow to cancel all these indi- vidual facts and emerge with social wages solely, and social rents, and social time discounts, and finally — as surplus over social cost — a social unnecessary profit? At all events, as long as we have — and recognize — separate and individual needs, separate demands, and separate biddings, and separate acceptings, we shall be recurrently forced to tres- pass upon the unity of the social organism. For some purposes, at any rate, the constituent cells will have to be taken as sep- arate individuals. And if the purchasers' bids are individual, so also must be the motives and the computations behind the bids. But consistently with all this, there can be no social mar- ginal utility by virtue of which market value can be explained or into which it can be resolved. The marginal bid expresses igio] Capitalization and Market Value. 143 merely an equality of utility between competing claims upon the bidders' resources — without any slightest suggestion as to the absolute size of these utilities, or as to the utilities to any other person or persons. H. J. Davenport. University of Missouri. Note: — In the errors under condemnation the present writer acknowledges his full and fair share of responsibility — not indeed as sole or as chief sinner, but as one among a goodly company. The social organism cult has beguiled many an unsuspecting wayfarer from his path: the trail of this serpent is to be found in nearly all of our gardens. The present article is, indeed, mostly in the nature of a confession of error and a recantation. Nor is this penitential exercise purely a self-imposed discipline ; for the most part it has been imposed upon the writer through the searching criticism of one of his students. It thus happens that another statement of the same line of argu- ment — ^by the real author of it — may be found in the March, igio, issue of the Journal of Political Economy — "The Capitalization Process," by D. R. Scott. .:s-<^ „-.n4A<2aiirMii-iL