The Social Functions of Profits

Profit seekers — those just after a quick buck — are often derided as being anti-social, as harmful to the interest of society at large.

Common objections to profits themselves are that they are unearned, that they drive up prices for consumer goods, and that excessive profits run others out of business. I am not sure how critics measure the interest of society, but I am pretty sure that by any standard the overwhelming evidence proves just the opposite. For simplicity, I want to deal just with competitive profits, and not monopolistic profits yielded from government privilege in a “mixed economy.”

The first thing to note about profits is that there are different kinds of profit measured in relation to time. Investment profit is a simple accounting measure weighting an action’s costs and revenues. Entrepreneurial profit takes investment profits and measures those against the opportunity costs of alternative decisions, of what could have been. Psychic profits are the purely intrapersonal gains or pleasures an individual experiences from action (like reading this commentary, I hope).

Another important point about the profit mechanism is that it is a system of profits and losses. In a consensually regulated market, entrepreneurs make predictions with capital they control to predict the future behavior of consumers. The entrepreneur is the sole risk bearer for all past decisions. Of course, others will most likely be affected by those past decisions, but employees and customers only risk their capital to the extent their have chosen to become investors.

Some see this profit as exploitative, saying the entrepreneur is skimming the wages of his or her employees. This indeed does happen — when government intervention prevents or undermines collective bargaining. In other cases, the profits reaped are what remain after paying wages and other factors of production. The entrepreneur, the first laborer, has foregone another profit opportunity and is rewarded last, after paying expenses, according to how efficiently he or she put capital to use.

Often, entrepreneurship is seen as a distinct field of economics rather than an integrated economic process of economic calculation. From reading Ludwig von Mises, he thinks of entrepreneurship more generally as making decisions under a condition of uncertainty to acquire and combine resources for a higher valued use.

Profits are Information

Profits are created when someone takes resources that are in less demand by consumers and transforms them into products of higher demand. Therefore, the existence of profit is a signal of a misallocation of resources, which consumers have implicitly expressed with their own actions.

Profits provide extra incentive to continue putting resources to their higher valued use, and it helps correct a prior misallocation of resources. Without a system of profit and loss, it would be impossible for those in control of capital resources to know the demand for one product vis-à-vis another.

Collectivized markets, like government policing, are incapable of devising such an efficient system because there is no reliable or automatic feedback mechanism, like prices in a market economy, to gauge consumer demand.

Profits as Anomaly

Profits come about from a change in market conditions. In a hypothetical scenario of universal complete information, profits would tend toward zero. If all businesses knew the future price and demand for all consumer products (goods and services), businesses would compete in such a manner that the costs of production would match the prices of the end consumer goods, less the depreciation and interest accrued on capital resources. However, because of  technological advances, changes in consumer tastes, and unforeseen events taking place in the future, there is a constant hashing of new information that must be deciphered.

It is this uncertainty about the future that, in the long run, makes profits possible.

Tending Toward Zero

As I said, profits are not the norm. They come about by correctly predicting future market conditions. As the market for a product matures, profits will tend to decline. This happens for several reasons.

The method of production becomes more refined, and competitors begin cutting into one another’s profits. One method of increasing profits again is to reduce costs. This encourages competitors to emulate that success in order to improve their own profits by reducing prices, which spurs the whole cost-cutting cycle again. There is a limit to the point where costs can be reduced, and that is the price level consumers are willing to pay for a product. Below that point, businesses will tend to cease production and invest their resources into more profitable areas and seek higher returns on investment.

Cooperatives tend to exist in well-established, more ossified industries with predictable consumer demands, like farming, where the necessity for entrepreneurship is decreased. A reason why relatively few cooperatives exist is because people can possibly invest their capital into more profitable ventures. Losses also tend to disappear for much the same reason. Poor performers tend to go out of business or end production of losing products.

Counterintuitively, the criticism of high profits falls flat. Far from being unearned, an entrepreneur is in a constant flux of reading the future demand of consumers and managing the resources available to him or her. The maligned profit motive has the tendency to reduce final consumer prices, as we see in the electronics market. It is in the centrally planned markets like health care and insurance that prices continue to skyrocket. We can also see how high returns inform less-efficient business of potential profit opportunities.

It should go without saying, but a genuinely free market does not exist and never has. If one had, cooperatives and worker-owned collectives would probably be more common because technology and information would spread more quickly and barriers to entry would be diminished. Corporations exist at the pleasure of the state, meanwhile, receiving subsidies and protection from liability and competition.

Do not think for a second those privileges come without a price. Without government-financed intellectual property enforcement, a foreign policy of American hegemony, bail outs and rent seeking, and a fiat credit monopoly, were else would these corporations get the money to pay off politicians?

Image credit: Conlawprof, with a Creative Commons license