21Oct
EconomicsOpinionPolitics

In Defence of Profits Part III

In Part I and Part II of this article, we showed that profits (at least in the absence of coercion or a state-conferred special privilege, such as a subsidy or monopoly right) are not derived from exploiting workers. But to really push back against the unjustified persecution of profits, it is not enough to prove that they are not exploitative. Instead, why are profits actually good?

Well, many of the reasons why profits are not exploitative also explain why profits are so vital. If, as we have shown in parts I and II, profits are an implicit form of interest that employees willingly pay to employers, then they are vital for the same reason as interest: interest provides a crucial incentive for some people to defer their consumption (and therefore risk foregoing it entirely) so that others who lack accumulated capital can engage in investment and/or consumption today.

Similarly, if we think of profits as a form of insurance premium, then it is obvious that they perform the vital function of incentivising employers to relieve their workers of the risks inherent in operating in an unpredictable marketplace.

But profits do much more than that.

Above all else, profits are a signal. More specifically, they are a signal that a firm is creating wealth. All the inputs that a firm uses in its production of goods and services have alternative uses, whether it be steel, rubber, office space or labour. The values of those alternative uses are the market prices of the inputs. If a firm pays $400 for a ton of steel, it does so because this is the minimum price it must pay on the open market to ensure that it outbids anyone else who might want that steel. If it pays $20 per hour for a worker, it does so because this is the minimum price it must pay to outbid anyone else who might want to employ that worker. The maximum price that the other party will be willing to pay is equal to the marginal revenue that each additional worker or ton of steel brings to their firm.

So when a firm sells a product for a profit, it means that the price it was able to obtain for the product was greater than the price of all the combined inputs, and therefore that, in terms of value, the product is worth more than the sum of its parts.

Therefore, a profit is a sign that a firm is actually creating wealth and allocating resources effectively. Crucially, profits reward firms that do this and also provide them with more capital with which to expand their operations.

Similarly, firms that produce products worth less than the value of their total inputs will be penalised in the form of a negative profit, otherwise known as a ‘loss’. If a car-producing firm can only sell its cars for less than production costs, it means that the finished car is worth less than the unprocessed chunks of steel, rubber, glass and plastic that went into it, because these raw resources had alternative uses (perhaps they could have gone into producing bicycles or smartphones) that have now been vitiated. Therefore, if a firm runs at a loss, it is actually destroying wealth.

Happily, firms that continue to make losses will eventually go bankrupt and will be forced to cease their destructive business practices. Therein lies the market’s mechanism for culling inefficient and wasteful firms and production processes.

So profits and losses ensure that businesses that serve consumers well survive and thrive, while businesses that fail to do so are squashed.

More than that, profits serve a vital purpose in directing investment in the economy. The economy has an average rate of profit determined by the underlying interest rate, but firms will always try to make profits above this average rate. Profits will be above average in industries where consumer demand is red hot relative to the supply of products provided by firms; in areas in which the economy has under-invested. Firms will try hard to spot these areas and direct investment capital towards them. So if ice cream makers are making above average profits, it means that the amount of capital dedicated to supplying ice cream is below the optimal level. To capture these high profits, more firms will invest in the equipment and expertise needed to produce ice cream, and the economy is recalibrated so that the capital structure is more optimally suited to consumers’ preferences.

So not only are profits perfectly benign, they are also incredibly important. Without them, we would have no way of knowing whether or not we are producing the right products, in the right quantity, or in the right way. So it is simply irresponsible for anti-capitalists to decry profits while never proposing any alternative mechanism for directing investment, rewarding efficient production techniques and punishing inefficient ones. Given that all this must happen effectively for human beings to thrive, it seems that the “profits before people” crowd do not really care about people at all.

John Hajek

John Hajek is the IPA Campus Coordinator at the University of Melbourne.

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