Are private profits necessary?

Private enterprise pits owners and workers against each other in a ceaseless struggle, a struggle that is ultimately self-defeating for everyone

Private business profits are the wellsprings of private wealth. Equalitarians therefore take a dim view of private profit-making.

Businesses may create profits by overcharging consumers. A more common tactic is to underpay employees. The truth is that owners and their profits can only thrive at workers’ expense and vice versa. In this conflict, owners have the whip hand because workers cannot afford to lose their jobs, although labor unions have helped level the playing field.

In the short run, the best way to reduce owner-worker conflict is to develop worker participation and profit-sharing schemes. In the long run, the solution is worker-owned businesses.

If the workers walk out

1. They stop being paid on Friday
2. Rent is still due
3. There may be no other employer in the town

If the owner waits

1. Income from other holdings continues
2. Savings absorb the gap
3. Time is on the side of the one who can afford to wait

This is what the whip hand means. Both sides need the deal, but they do not need it equally urgently, and the one who can wait longer sets the terms. A union, on this account, exists to make the two columns look more alike.

The profit system is inherently inefficient

Profit is an unnecessary, extra cost piled on top of genuine production costs. As such, it is wasteful. If this waste were eliminated, prices would fall and everyone would be better off. As philosopher Ted Honderich has stated this case,

“If there are two ways of [producing] some valuable thing, and the second way involves not only the costs of [producing] it . . . but also [unnecessary] profits of millions or billions of dollars or pounds, then . . . the second way is patently and tremendously less efficient.”

Ted Honderich³²

The real costs

The first wayWhat it takes to make it

The real costs And profit

The second wayThe same thing, and a charge on top

Honderich’s argument in one picture. The same valuable thing arrives at the end of both columns. One of them costs more. Efficiency is doing the job with less, so on this reading the taller column is simply the worse method.

Quite apart from its injustice and inefficiency, the profit system does not give us the goods that we need

Private businesses exist to make money. They must make money right now, or at least soon, not at some indefinite point in the future. Their focus is accordingly on immediate profit opportunities for the owners (that is, the few), not on the present and future needs of customers (that is, the many). In effect, there is a glaring conflict between “production for profit” and “production for people’s use,” and under our existing system “production for use” takes the hindmost. As history professor and popular commentator Howard Zinn explains this:

“The profit motive . . . has . . . distorted our whole economic and social system by making profit the key to what is produced and therefore leaving important things unproduced and stupid things produced [as well as] leaving some people rich and some people poor.”

Howard Zinn³³

Young European protestors against “global capitalism” have made the same point on their banners and placards: “People Not Profit.”³⁴

What should we make tomorrow?

Production for profitWhatever returns the most money soonest. The question is who will pay, and how much, and how quickly.

Production for useWhatever people most need. The question is who is going without, and what would help them.

Sometimes the two questions have the same answer, and nobody notices the difference. The claim on this side is that when they part company, only one of them is actually being asked.

Even when the profit system produces the right goods, it denies them to those who need them the most, the poor

This may be tolerable in some consumer areas, but not in areas of basic need such as food, shelter, or healthcare. Cynthia Tucker, editorial page editor of The Atlanta Journal–Constitution, explains:

“The profit motive doesn’t improve every enterprise. . . . [The] healthcare industry [currently] . . . exist[s] to make money. . . . They jack up the prices . . . and restrict . . . [service] to those who can afford it. . . . [This] has gone too far.”

Cynthia Tucker³⁵

The lit ones can pay for it. Nothing is wrong with the treatment, and nothing is wrong with the factory that makes it. The objection on this side is to the rationing rule, which is the price, and which asks what you have rather than what you need.

Prices and profits work together as an indispensable signaling device

The desire and need, that is, the demand for particular products is constantly shifting. People choose this now, that later. Meanwhile the supply of products also shifts depending on an infinite number of variables (for example, weather affects the supply of crops). Information about both demand and supply is communicated to everyone by prices. Higher prices signal more demand or less supply, lower prices signal the opposite. This radically simplifies economic life.

As important as prices are for signaling conditions, they cannot do their work without profits. For example, assume that I am in the applesauce business and that profits are high because of heavy consumer demand or unusually low apple or sugar costs. The high profits give me the cash (or the credit) to step up my production. In addition other producers will likely do the same, and some new producers may be attracted into the business. In either case, supply will rise until profits fall back to more modest levels.

On the other hand, if profits fall far enough, supply will contract, so that output will again be brought into better balance with consumer demand. Everybody who wants applesauce will then get it, and producers will earn the profits necessary to keep recreating a balance. The key point to remember is that the quest for profits in a competitive market tends to increase supply, thereby lowering, not raising consumer prices. The quest for profits also drives competitors to work hard at lowering their costs. The dynamic of competition eventually translates lower costs into lower prices as well.

1. 1People want more applesauce
2. 2Profits in applesauce rise
3. 3Old makers expand, new ones arrive
4. 4More applesauce on the shelf
5. 5Profits fall back, and the price with them

Nobody ordered any of this. The whole sequence runs on one number, and step five is the point: on this account the high profit is not the end of the story but the thing that destroys itself by attracting company.

The profit system is especially good at identifying “chokepoints” or “bottlenecks” in the economic system, places where production is difficult or inefficient and where profit “tolls” are consequently high. For example, Mark Kurlansky in his book Cod has sketched the development of the huge cod-fishing industry since the sixteenth century, an industry that in earlier centuries furnished a high percentage of the total protein available to Europeans.³⁶

• The shipsAt first the chokepoint was the ships, which were too small and flimsy. This attracted capital and better ship designs, so that the profit of ship owners eventually fell.
• The small portsThe fish could not be kept long without processing, and nearby processors were able to charge high rates.
• The large portsAs ships got faster, the small ports were bypassed. Boston and its like were much more efficient, but still commanded high prices.
• NobodyRefrigerated container ships enabled fishing companies to bypass processing centers entirely.

Step by step, investment flowed to where the process was least efficient, where high profits signaled both a problem and an opportunity. The poor benefited especially, because it meant that they could afford more protein in their diet.

Even Karl Marx, the father of Communism, acknowledged that the profit system reduces prices. He said as much in the Communist Manifesto of 1848:

“The cheap prices of its commodities are the heavy artillery with which [the profit system] . . . compels all nations, on pain of extinction, to adopt the [profit] mode of production.”

Karl Marx and Friedrich Engels³⁷

When the Soviet Union came into being during World War One as the first Communist state, many of its founders assumed that both prices and profits would be abolished. This was complicated by Marx’s puzzling failure to suggest exactly how this might be done. A decision was eventually reached to keep prices and profits, although the latter would be “for all.”

Economist Ludwig von Mises responded that a system of public prices and profits was impossible, that only private prices and profits could provide the necessary information flow and calculations, and thus organize, direct, and grow an economy. Von Mises summarized the problem in this way:

“It is not enough to tell a man not to buy on the cheapest market and not to sell on the dearest market. . . . One must establish unambiguous rules for the guidance of conduct in each concrete situation.”

Ludwig von Mises³⁸

Von Mises’s thesis was violently disputed but never successfully rebutted, either in theory or in practice. The Soviet Union by the 1960s had from five to nine price and profit systems according to varying accounts, but none seemed to work.³⁹ As Oystein Dahle, a Norwegian oil executive, noted, “Socialism collapsed because it did not allow prices to tell the economic truth.”⁴⁰

Not every equalitarian, to be sure, accepts the notion that free prices and profits are necessary as a signaling device. A letter writer to the Mises Institute, for example, argued that real “socialism” has yet to be tried: “The Soviet Union was a system of capitalism run by the state. Nothing more, nothing less. . . . The alternative to a centrally planned capitalist economy or a laissez-faire capitalist economy is a decentralized moneyless marketless economy.”⁴¹ The writer did not specify, but probably had in mind a series of independent, isolated economic communes.

Profits are also indispensable as a system of positive and negative incentives that, importantly, are objectively scored

We usually think of the game of business being scored in profits, but it is even more importantly scored in losses and bankruptcies. As economist Wilhelm Röpke wrote:

“Since the fear of loss appears to be of more moment than the desire for gain, it may be said that our economic system (in the final analysis) is regulated by bankruptcy.”

Wilhelm Röpke⁴²

Economist Milton Friedman similarly argued that the “profit” system should really be called the “profit and loss” system, that the “stick” is at least as important as the “carrot.”

The carrot of profit and the stick of loss in general persuade us either to change or to accept change, something that people are more often than not reluctant to do. Economic growth by definition entails change; without it we would all still be hunting and gathering, or at least those few of us who could still survive within such a restricted economic environment. Yet many people are simply uncomfortable with change, others may be lazy, and vested interests will always fight hard against change if they can.

People can of course be motivated to change by other, more directly coercive methods. Stalin bent millions to his will through sheer terror. But, as a general rule, coercion is extremely inefficient, because people have a thousand ways of resisting, passively as well as actively. If one reads the memoirs of large slaveholders in the American South before the Civil War,⁴³ they are full of fretting about the incessant passive resistance of the slaves, even in the face of cruel punishments.

A business is doing the wrong thing

The stick of lossNobody has to be told. The money runs out, the business closes, the people and the machines go somewhere they are wanted more.

The stick of forceSomebody decides, and somebody enforces. It works, up to a point. Röpke and Friedman argue the point comes early, because people can always drag their feet.

On this side of the argument, bankruptcy is not a failure of the system. It is the system working, and it is the half of it that does the most.

At first glance, it might seem that the profit system just produces what rich people want, not what the greater number of people need. This is wrong

The profit system is guided by profits, and the greatest profits are earned, not by catering to the wants and whims of the rich, but rather by meeting the genuine needs of large numbers of people. Economist Ludwig von Mises explained:

“Mass production . . . [is] the fundamental principle of [profit-seeking] industry . . . big business, the target of the most fanatic attacks by the so-called leftists, produces . . . for the masses.”

Ludwig von Mises⁴⁴

Economist Milton Friedman further elaborated on this point: “Progress . . . over the past century . . . has freed the masses from backbreaking toil and has made available to them products and services that were formerly the monopoly of the upper classes. . . .”⁴⁵ “The rich in Ancient Greece would have . . . welcomed the improvements in transportation and in medicine, but for the rest, the great achievements of [profit seeking] have redounded primarily to the benefit of the ordinary person.”⁴⁶

BooksCopied by hand for the few. Now everywhere.

Glass windowsA luxury. Now in every wall.

TravelThe rich went abroad. Now most people can.

ServantsThe one thing the rich had that got scarcer, not commoner.

Friedman’s point in four cells. Almost everything the rich once had alone has spread outward. The struck-through cell is the exception, and on this side of the argument it is the exception that shows what the machine is actually for.

It is natural to feel that something is very amiss when the profit system stops making shoes before all the poor children have them. It is equally puzzling and disturbing when the profit system seems incapable of reducing healthcare prices, so that they increase faster than any other prices save a college education, and become increasingly unaffordable for the poor. But if one looks closely at what is really happening, it will be apparent that profit-making is not to blame.

Nobody wants poor children to go without shoes. But we still operate in an environment of economic scarcity, which means that trade-offs must continually be made. If we keep making shoes, we will have more of them and each pair will be cheaper and cheaper. But then we will have to accept less of something else and higher costs for each unit of that. The only “waste” in the system that one can fairly point to is the portion of rich people’s income that is spent on luxuries.

The problem of healthcare differs from the problem of insufficient shoes for poor children. The difference is that the healthcare industry has been socialized, fully in Britain and Canada, half or more (in terms of payment source) in the United States. Consequently, contrary to Cynthia Tucker, profit-making is only part of the equation, and mixing profit-based and government-led systems virtually guarantees failure.

The crux of the problem is that government has assisted drug companies and hospitals in creating monopolies, which enable them to price higher and higher without the usual restraint of market competition. Normally rising prices from government sponsored monopolies would reduce demand. Government has solved this problem by subsidizing the medical system’s ever rising monopoly prices. Subsidies mean that demand does not fall, it actually rises. The usual solution for rising prices would be more supply, but government actually prevents that through regulations which minimize what nurses are allowed to do, refusing to allow more medical schools, and many other steps.

1Government helps create the monopoly

2Prices rise, with no competition to stop them

3Government subsidizes the higher prices

4Demand rises instead of falling, and supply is held down

Then back to step two, higher each time. Subsidized demand, together with the same or less supply, leads to ever higher prices, then more subsidies, then still higher prices, in a vicious circle that particularly injures the poor, the aged, and the unemployed.

It is also understandable that many people think of profits as “stolen” from workers

After all, do not worker’s wages come out of the “skin” of owners and vice versa? Is this not a classic example of a “zero-sum game”? Surprisingly, the answer is no.

A business divided will not stand. Owners and workers must cooperate if they are to survive and thrive and, in particular, to hold their own against competitors, who are surely the more meaningful opponents. Furthermore, although pay raises and bonuses feel good, and could be taken out of profits in the short run, we have seen that profits are needed to pay for investment, either directly or by attracting investors. And it is precisely this stream of investment that provides workers with the tools, training, and other support necessary to make them more productive, which in turn justifies and pays for their raises or bonuses.

Running a successful business is always a balancing act. If wages are too low, workers will leave. If wages are too high, profits will be too low to pay for productivity-enhancing investments or other planned expansion. Workers should applaud productivity-enhancing investments, because studies show that, over time, they get all the return on such investments in the form of higher wages, or at least all the return that does not go to customers in the form of lower prices.

Gold is profits, grey is wages. It is not surprising, on reflection, that over the years a business’s profits and wages tend to rise or fall together, with profits leading a bit, or that this same pattern holds for the economy as a whole. An illustration of the claim rather than a measurement.

Nor is it surprising that overall employment tends to follow profits, since businesses use profits to invest in workers as well as capital equipment. The only part of profits the workers in general do not directly benefit from is, again, business owners’ luxury spending, and of course workers in luxury industries even benefit from that. On balance, a rise in genuine, sustainable profits is very good news for an economy, because it means that higher employment levels and wages are coming next.

Raising pay in one company will not increase the overall share of “labor”

Let us assume that a “widget” business is shortchanging its workers on pay and not even investing enough in the business to maintain its existing plant and equipment. This may be because the “widget” business is failing, and the profit-making system is forcing it to wind down and its employees to move on to better opportunities. If the business is not failing, it presumably will be failing soon, because in that case the owners’ greed will cause it to lose its best workers and become less and less competitive.

But assume that the business is sound, is simply underpaying its workers, that the workers strike, that wages are substantially raised, and that the owners are compelled to stop being greedy. In this case, a blow has been struck for Labor and against Capital, has it not? Well, no. The answer is no because the workers will take their new wages and buy things with them. These new purchases will in turn swell the sales and profits of other business owners, so that economy-wide profits will be unaffected, just as Labor and Capital aggregate shares will be unaffected.

1The widget workers strike and win

2They spend the raise

3Other owners’ sales and profits rise

4Profits across the economy: unchanged

The victory at step one is real, and the workers at that firm are better off. The claim on this side is only about the last box. In the meantime, the greedy owners may try to compensate by raising prices, which will probably backfire by reducing revenues further, and if it does not, it raises widget prices for consumers who are also workers, particularly hurting those who are retired or otherwise living off savings.⁴⁷

Employee business ownership creates as many problems as it solves

Advocates of employee ownership or profit-sharing schemes see both as a way to create a better motivated and thus more efficient workforce, a more just workplace environment, and stronger consumer demand.⁴⁸ At first glance, it might seem that no one could possibly oppose such a proposal. But, in reality, there are important objections to it.

In the first place, workers are not an abstraction. They are individual human beings who grow old and want to retire. What then? Usually, the retiring employees want to sell their shares and profit from the sale, so they will sell to the highest bidder, which probably will not be other employees. If, alternatively, shares can only be sold to other employees at modest prices, then the employees have not been full equity owners. In addition, the restrictions on share transfer may make it impossible for the firm to raise outside capital.

She wants to sell her share and retire on it

Sell to anyoneShe gets the full price, from whoever bids highest. That buyer is probably not another employee, so the firm stops being worker-owned.

Sell only to employeesThe firm stays worker-owned, but at a price she did not set. On this account she was never really a full owner.

Both doors close something. This is the objection at its narrowest, and it is about one retirement rather than the whole idea.

Most importantly, if employees owned the entire economy, saving would plummet. As we have seen, it is the special role of the rich to be forced to save and invest—they alone have more than they can possibly spend. Profit-sharing plans are also, unfortunately, subject to the same criticism: more often than not, they represent a form of variable employee compensation, not a true sharing of “profits.” In true profit-sharing plans, employees leave some (sometimes all) of their “profits” in the business, just as outside owners do.

The kind of macroeconomics commonly taught in schools is misleading: it does not adequately acknowledge the role of profits

Economist David Ricardo said in the early nineteenth century that “Nothing contributes so much to the prosperity and happiness of a country as high profits.”⁴⁹ Ricardo was right, and given the truth of what he said, one must wonder why modern macroeconomists have so little to say about profits.

Macroeconomics texts are full of discussion about production growth, employment, inflation, etc., but profits are kept out of sight. If profits are discussed, it is generally in the microeconomics section of a text, the part that concerns individual businesses and industries, not the economy as a whole.

GrowthA chapter

EmploymentA chapter

InflationA chapter

ProfitsFiled under microeconomics, if at all

An argument about what a book leaves out is a hard one to make, and this is the only claim on this side that is about teaching rather than about how an economy works. Judge it on its own.