The Suntory and Toyota International Centres for Economics and Related Disciplines

The Principle of Increasing Risk

Author(s): M. Kalecki
Source: Economica, New Series, Vol. 4, No. 16 (Nov., 1937), pp. 440-447
Published by: Wiley on behalf of The London School of Economics and Political Science and
The Suntory and Toyota International Centres for Economics and Related Disciplines
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 [NOVEMBER

The Principle of Increasing Risk

By M. KALECKI

THE subject of this paper is the determination of the size

of investment undertaken in a certain period by a given
entrepreneur. He intends, for instance, to build a factory
producing a certain product. He is faced with given market
conditions: he knows the price of the product in question,
the level of wages and of prices of raw materials, the cost
of construction and the rate of interest. Besides he has
some rather vague ideas as to the probable future change
of prices and costs. This knowledge is the basis for the
planning of investment, i.e., for the choice of the amount
of capital k (measured in terms of money) to be invested
and the method of production to be applied.
With a given amount of capital k and a given method of
production the entrepreneur is able to estimate the series
of future returns (differences between revenues and effective
costs) q1, q2 ..... .q. during the prospective life of the
factory. We shall call the rate e at which the series of
returns must be discounted in order to obtain the amount
invested k-the efficiency of investment,1 whilst by
prospective profit p we denote the product k.e. Now we
can assume that with given amount invested "k the entre-
preneur chooses such a method of production as would
maximise the efficiency of investment or what amounts
to the same (k being given) the prospective profit p = ke.
Thus to every value of k there corresponds a definite value
of maximum prospective profit pm:
pm =f(k).
Now the method of production being chosen for each
value of k the entrepreneur has still to define the optimum k,
i.e., the size of investment. He must charge the capital
invested at the market rate of interest and make also some

'This definition is identical with that of Keynes' marginal efficiency of an asset.

440

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 1937] THE PRINCIPLE OF INCREASING RISK 441

allowance for risk whose rate we denote by r. Thus the

entrepreneur's prospective gain g is
g =pm-(p +) k.
The entrepreneur will obtain the maximum gain at the
value of k which satisfies the equation

dpm ==
dk +
and this value of k is the optimum amount to be invested.

Now -dPnfJ'(k) is nothing else than the efficiency of

small capital addition dk to the amount invested k -
supposing that both k and k+dk are invested with optimum
method of production. We shall callf'(k) marginal efficiency
of investment. We can consequently say that the size
of investment ko is determined by that level at which margin
efficiency of investment is equal to the sum of the rate
of interest p and rate of risk .
As can be easily
seen from the chart
the optimum
amount ko to be
invested is finite
only if marginal
efficiency of invest-
ment falls when k
exceeds a certain d
value. This fall
may be caused
by: (I) large scale
dis-economies; (z)
imperfect competi- p
tion. The first reason - k
though generally
admitted seems to
be not very realistic. FIG. I
It is quite clear
that its technological interpretation is wrong: it is right
that every machine has an optimum size but why not let
ten (or more) machines of given type work ? Thus only
the argument of difficulties of management arising out
of the large scale of enterprise remains. But also that is
doubtful (why not start ten factories instead of one with

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 442 ECONOMICA [NOVEMBER

ten independent directors ?) and at any rate concerns only

such industrial giants as are far above the average size of
existing enterprises.
The explanation of the limited size of investment by
imperfect competition is more realistic but also does not
cover the ground. The imperfection is often slight and in
that case immense enterprises would be planned.' Further
the imperfect competition cannot explain the fact that in
a given industry at the same time large and small enterprises
are started. Thus there must exist a factor restricting
the size of investment which we have not taken into account
in the above argument.

II
We have assumed till now-as is usually done-that
the rate of risk is independent of the amount invested k.
And it is this assumption which has to be dropped, I think,
in order to obtain a realistic solution of the problem of
"limited investment."2
There are two reasons for the increase of marginal risk
with the amount invested. The first is the fact that the
greater is the investment of an entrepreneur the more is
his wealth position endangered in the event of unsuccessful
business.
The second reason making the marginal risk rise with
the size of investment is the danger of " illiquidity." The
sudden sale of so specific a good as a factory is almost always
connected with losses. Thus the amount invested k must
be considered as a fully illiquid asset in the case of sudden
need for "capital." In that situation the entrepreneur
who has invested in equipment his reserves (cash, deposits,
securities) and taken " too much credit " is obliged to
borrow at a rate of interest which is higher than the market
one.
If, however, the entrepreneur is not cautious in his
investment activity it is the creditor who imposes on his
calculation the burden of increasing risk charging the
successive portions of credits above a certain amount with
rising rate of interest.3
1 If the competition is perfect and the marginal efficiency is greater than the sum of rate
of interest and risk, ko is infinite (see Fig. I).
2 The principle of increasing risk was already used in my article "A Theory of the
Business Cycle," Review of Economic Studies, February, I937, pp. 84-85.
3 See M. Breit, "Ein Beitrag zur Theorie des Geld- und Kapitalmarktes" Zeitschrif: fuer
Nationaloekonomie, Banid VI, Heft 5, p. 641.

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 1937] THE PRINCIPLE OF INCREASING RISK 443

The amount invested ko is now given by t

the marginal efficiency of investment is e
marginal risk C- and the rate of interest p.
is not a horizontal curve as in Fig. i but an u
The point of intersection with the margina
determines the size of investment and this point exists
even in the absence of large scale diseconomy and imperfect
competition (Fig. 2).
Now the various
sizes of enterprises
started in the same
industry at a given m ______v_
moment can be easily
explained. The smaller
is the own capital of
an entrepreneur in-
vesting the amount k
the greater the risk
he incurs. For his
possible losses bear a e
greater proportion to k
his wealth and-since
the amount of credits ko
considered by his FIG. 2
creditors as "normal"
is in a ce'rtain proportion to his own
"illiquidity." is greater too.
Thus the smaller is the own capital the higher lies the
p + a- curve and-as is easy to see on the chart-the smaller
is- the amount invested k,. The enterprises started in a
given industry at a given moment are not of equal size
because the own capital of entrepreneurs is not equal. The
"business democracy" is a fallacy: the own capital is
a " factor of investment."

ILI
In the case represented in Fig. 2 we have constant returns
to the scale (the imperfect competition is neglected) and
thus constant marginal efficiency of investment. Thus the
marginal efficiency curve represents a constant method of
production.
Let us now consider what happens if the rate of interest

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 444 ECONOMICA [NOVEMBER

is lowered. The p + aC c
intersection with the mar
right (Fig. 3). The
method of production
applied by the entre-
preneur in his plan mreg 7 yn
does not change whilst
the size of investment
increases. Consequent-
ly so long as we can
consider the influence
of imperfect competi-
tion as negligible and
thus have constant re- 'a
turns to the scale the _ k

change in the rat of FIG. 3

interest does not affect
the method of production admitted by the entre
plans but only the size of investment planned.
This statement seems to be in contradicti
dassical theory of marginal productivity of
labour but the contradiction is only apparen
of departure of the classical doctrine is a drastic
model of production in which the quantity of
defin'ite function of the amount of " real"
labour used. The necessary condition of equ
the equality between the marginal product
factor "and its price divided by the price of
the case of constant returns to the scale (h
production function) this is also a sufficient co
long run equilibrium, for with constant returns
productivities' equations exclude the exis
entrepreneur's gain. If the rate of interest
towards a new long run equilibrium must t
which the marginal productivity of capital i
of labour higher, and more capital is used in
to labour. But the theory says nothing about t
influence of the fall of the rate of interest on
the entrepreneur. Such a fall in the case of con
to the scale (and if our principle of increasin
taken into account) must create a tendency to pl
of infinite size and with indefinite metlhod of
(every method applied on infinite scale give

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 1,937] THE PRINCIPLE OF INCREASING RISK 445

profit). Only after the output of the product is suddenly

increased its price falls and this makes again possible the
restoration of long run equilibrium in which the marginal
productivity equations are satisfied.1'
Thus our problem was quite different from that of classical
theory. We examined the planning of the entrepreneur
in a given situation wlhich in general is not the position of
long run equilibrium. We tried to find the factor limiting
the size of the investment planned which, as we see, is
non-existent in the classical theory in the case of industry
subject to constant returns to the scale and not in the
position of long run equilibrium. And also our statement
that the fall of the rate of interest does not affect the method
of production but only the scale of investment plans referred
only to the plans but not to the situation arising out of
their realisation.
The classical thesis of the low rate of interest causing
the use of more capitalistic method of production was
often applied not only for long run equilibrium position
but also for entrepreneurs' planning in " disequilibrium."
This interpretation is of course wrong and as we have shown
above, if we neglect imperfect competition and introduce
the principle of increasing risk the fall of the rate of interest
has no immediate effect on the method of production applied
in the plans of entrepreneurs.
IV
One intricate point is still involved in the matter above
examined. We mean the problem of the rate of investment
decisions per unit of time. But before dealing with it we
shall transform the
Fig. 2 a little. We sub-
tract from the ordin- ___________ /
ates of both marginal
efficiency curve and
p + T curve the rate
of interest p and
thus obtain the margi-
nal net profitability
(marginal efficiency
minus rate of interest) k
curve and the marginal FIG. 4
1This treatment is however quite formal, for in reality cumulativ
causes (if the rate of interest is not raised) either hyperinflation or flu
position of long run equilibrium.

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 446 ECONOMICA [NOVEMBER

risk curve. The point of intersectio

gives of course the same value ko as above.
Let us divide the time into equal periods At short enough
to consider the economic situation, i.e., the level of prices,
wages, etc., as constant within the period (the change of
this situation is thus to be imagined as concentrated at
the beginning of the period). In each period the entrepreneur,
takes so much of investment decisions as to equate at the
end of it the marginal risk to the difference between the
marginal efficiency and the rate of interest. Thus it would
seem that no investment decision at all will be undertaken
in a period if the " economic situation " remains the same
as in the preceding one, because the point of intersection
of the marginal risk curve and the marginal net profitability
curve lies on the ordinate axis at the beginning of the period
considered. This is, however, wrong. For one thing does
change in the position of our entrepreneur: during the
period At he saves in general a certain amount s. At out
of his income.

@. net ci- A~~~~~~~~~~~~~~~~~~~~~~~~~~~~. ._.......

FIG. 5

This accumulation of savings causes a parallel shift of

the curve of marginal risk to the right. For the entr
preneur can invest the new accumulated amount witho
reducing his safety or increasing illiquidity. He may inve
even more: if the relation of his net indebtedness (differen

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 I937] THE PRINCIPLE OF INCREASING RISK 447

between debts and claims) to his own capital is 6, he can

freely invest s(i+8) At.,
Such is then the amount of investment decisions if the
situation in the period examined is the same as in the
preceding one. If, however, this is not the case and the
net profitability curve has shifted, also an amount c due
to the change of the economic situation will be invested
(see the chart). The investment planned during the period
At consequently amounts to s(I + 8) At + c and thus the
rate of investment decisions during the period is

d=s(i +S)+E *

c depends on the velocity of change of marginal net profit-

ability. We denote it by v and thus have:

d =s( I+d) + V
This equation means that the rate of investment decisions of
a single entrepreneur depends on his capital accumulation and
on the velocity of change of marginal net profitability.

1 It is now clear that the marginal risk + rate of interest curve dealt with in the preceding
paragraphs must be taken in the position at the end of the period in which investment activity
was considered.

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