Income Defined by Consumption

The change in the ending value of the capital equipment compared with its starting value due to profit maximizing decisions.

There might be an involuntary change in the value of his capital equipment beyond his control or expectation such as:

• a change in market values
• obsolescence
• the mere passage of time
• destruction by war or earthquake.

Let us only take the foreseeable losses such as the depreciation of the equipment.

This is similar to Marshall’s supplementary cost as the expected depreciation which does not enter into prime cost.

• But my definition is different.

When we compute the entrepreneur’s net income and net profit, we usually deduct the estimated amount of the supplementary cost from his income and gross profit as defined above.

To the entrepreneur, the supplementary cost is virtually the same as though it came off his gross profit.

As a producer, he decided whether or not to use the equipment.

• This makes prime cost and gross profit significant concepts.

But as a consumer, the supplementary cost to him is the same as a part of the prime cost.

Hence, we shall:

• come nearest to common usage.
• arrive at a concept which is relevant to the amount of consumption, if, in defining aggregate net income, we deduct the supplementary cost as well as the user cost, so that aggregate net income is equal to A - U - V.

Windfall Loss is the actual loss from unforeseen changes.

The causal significance of net income lies in the psychological influence of the magnitude of V on the amount of current consumption, since net income is what we suppose the ordinary man to reckon his available income to be when he is deciding how much to spend on current consumption.

This is not the only factor of which he takes account when he is deciding how much to spend.

It makes a considerable difference, for example, how much windfall gain or loss he is making on capital account.

But there is a difference between the supplementary cost and a windfall loss in that changes in the former are apt to affect him in just the same way as changes in his gross profit.

It is the excess of the proceeds of the current output over the sum of the prime cost and the supplementary cost which is relevant to the entrepreneur’s consumption; whereas, although the windfall loss (or gain) enters into his decisions, it does not enter into them on the same scale — a given windfall loss does not have the same effect as an equal supplementary cost.

We must now recur, however, to the point that the line between supplementary costs and windfall losses, i.e. between those unavoidable losses which we think it proper to debit to income account and those which it is reasonable to reckon as a windfall loss (or gain) on capital account, is partly a conventional or psychological one, depending on what are the commonly accepted criteria for estimating the former. For no unique principle can be established for the estimation of supplementary cost, and its amount will depend on our choice of an accounting method.

The expected value of the supplementary cost, when the equipment was originally produced, is a definite quantity.

But if it is re-estimated subsequently, its amount over the remainder of the life of the equipment may have changed from a change in our expectations.

The windfall capital loss being the discounted value of the difference between the former and the revised expectation of the prospective series of U + V. It is a widely approved principle of business accounting, endorsed by the Inland Revenue authorities, to establish a figure for the sum of the supplementary cost and the user cost when the equipment is acquired and to maintain this unaltered during the life of the equipment, irrespective of subsequent changes in expectation. In this case the supplementary cost over any period must be taken as the excess of this predetermined figure over the actual user cost.

This ensures that the windfall gain or loss shall be zero over the life of the equipment.

But it is also reasonable in certain circumstances to recalculate the allowance for supplementary cost on the basis of current values and expectations at an arbitrary accounting interval, e.g. annually.

Businessmen differ on which course to adopt.

They might define:

• the basic supplementary cost as the initial expectation of supplementary cost when the equipment is first acquired
• the current supplementary cost as the supplementary cost recalculated up to the current values and expectations .

I define supplementary cost as that which comprises those deductions from the entrepreneur’s income before setting aside the part of his income for:

• declaring a dividend, if a corporation or
• consumption, if an individual

Windfall charges on capital account are not going to be ruled out of the picture. It is better to assign an item:

• to capital account
• to include in supplementary cost only what rather obviously belongs there.

Any overloading of the former can be corrected by allowing it more influence on the rate of current consumption than it would otherwise have had.