August 20th, 2015
Have A Question?
It still surprises me how often the profit motive is demonized. Terms such as “Obscene Profits,” “Greedy Business,” “Corporate Greed” are prevalent in the media (which, by the way, generates HUGE profits from advertising in order to pay the salaries of the very journalists attacking “profits”).To be sure, success is often vilified out of envy and jealousy; but believe it or not, many people still try to make the case that profits are bad for society as a whole.
As I have pointed out in (The Most Important Economic Schools of Thought in 1 Lesson) when centrally planned ideologies are put into practice, the actual outcomes are far different than predicted by proponents of Socialism (as well as Communism and Progressivism). History has shown that people in these economies have great difficulty affording goods and services that people in capitalist societies can afford with ease. Without profits, prices should be lower, right? But they are not. So what gives?
Profits play an important role in the efficient allocation of scare resources to their most valuable uses. Just as I have shown previously in (Economic Concept: Supply and Demand), prices provide valuable, timely and accurate information to producers and consumers in a free market economy. The same holds true for wages (Economic Concept: Labor and Wages, since wages are simply the prices of different types of labor).
In the same way, profits represent the prices of the other factors of productions: the labor/skill of the entrepreneur, the risk taken by owners of capital invested in the business (as well as the time they have to wait to get paid back), the opportunity costs of the owners and entrepreneurs (remember, there is always an alternative use of time and talent) opportunity cost. Through competitive markets, business owners cannot sustain profits higher than what reasonably compensates them for their effort and investments; otherwise, other businesses would be attracted in to compete for these high profits (and this additional supply would bring profits back down).
The opposite occurs if profits are too low. In this way, (just as with prices of goods and services) prices provide important signals about the allocation of scarce resources. So there’s a cause and effect: Higher profits attract new businesses (and investment) and lower profits (or even losses) indicate that resources should be deployed elsewhere. It’s a natural check-and-balance that forces the market (whether happily or begrudgingly) to adjust.
Profits are also an incentive for business owners to reduce costs, increase efficiencies and innovate. In this way, profits are the motivation not only to produce products and services, but to produce them in a ever improving ways. That’s why products and services in the private sector tend to become better and cheaper over time. The opposite (rising prices and falling quality) occurs in centrally-planned economies or government run programs (even though there are profits included in the prices). Wonder why healthcare insurance costs have risen so much? The growth of Medicare, Medicaid and The Affordable Care Act have increasingly replace the free market.
Losses (negative profits) play an equally important role in the allocation of scarce resources. Losses signal that either the good or service produced is not valued enough to cover costs OR the process of producing that good or services is inefficient. In the presence of losses, a business must quickly respond to either reduce the costs of production or improve the product (or both). Nonetheless, a business will not produce at a loss indefinitely and investors in the business will soon take their capital elsewhere. In this way, “bad” businesses go out of business if they don’t quickly correct their mistakes. While this may be unfortunate for the owners and employees, society will be better off, because those resources can be reallocated to more productive uses.
Many have argued that in certain industries, profits should not be permitted, in order to keep prices down for the public good (such as Healthcare, Pharmaceuticals, Mail Delivery, Utilities, etc.). In light of the function of profits (and losses), this is a bad idea. Keep this in mind when profits are demonized, it is important to The Future of Your Wealth!