The role of profits

By Dr Frank Shostak

Some commentators regard profit as the outcome of exploitation of some individuals by some other individuals. 

Profit however, has nothing to do with exploitation – it is about the most efficient use of real savings. Profit as such is an indicator as it were, whether real savings are employed in the best possible way, in promoting individuals’ life and wellbeing.

If the employment of real savings results in the expansion of the pool of real savings, all other things being equal, this is indicative that the employment of real savings was done in a profitable way. Conversely, if there is a decline in the pool of real savings then this could be indicative of a loss. 

Profit and loss in the market economy

Profit and loss can be only ascertained in the market economy where the prices of goods and the prices of various factors of production are established. The existence of money is the key in the formation of the prices of goods and of the factors of production i.e. the quantity of money per unit of a good or a unit of a factor of production.

Profit emerges once an entrepreneur discovers that the prices of certain factors are underpriced relative to the potential price of the products that these factors, once employed, could command. 

By recognizing the discrepancy and acting upon it, an entrepreneur removes the discrepancy, i.e., eliminates the potential for a further profit.  

According to Henry Hazlitt, 

In a free economy, in which wages, costs and prices are left to the free play of the competitive market, the prospect of profits decides what articles will be made, and in what quantities – and what articles will not be made at all. If there is no profit in making an article, it is a sign that the labor and capital devoted to its production are misdirected: the value of the resources that must be used up in making the article is greater than the value of the article itself.

For an entrepreneur to make profits, he must engage in planning and anticipate consumer preferences. Consequently, those entrepreneurs who excel in their forecasting of consumers’ future preferences will make profits. 

On this Ludwig von Mises wrote,

Thus profit and loss are generated by success or failure in adjusting the course of production activities to the most urgent demand of the consumers. Once this adjustment is achieved, they disappear. The prices of the complementary factors of production reach a height at which total costs of production coincide with the price of the product. Profit and loss are ever-present features only on account of the fact that ceaseless change in the economic data makes again and again new discrepancies, and consequently the need for new adjustments originate.

Planning and research however can never guarantee that profits are going to be made. Various unforeseen events could upset entrepreneurial forecasts. Errors, which lead to losses in the market economy, are an essential part of the navigational tools, which direct the process of allocating resources in an uncertain environment in line with what consumers’ dictate. Uncertainty is part of the human environment, and it forces individuals to adopt active positions. 

Furthermore according to Mises,

It is not the capital employed that creates profits and losses. Capital does not “beget profit” as Marx thought. The capital goods as such are dead things that in themselves do not accomplish anything. If they are utilized according to a good idea, profit results. If they are utilized according to a mistaken idea, no profit results. It is the entrepreneurial decision that creates either profit or loss. It is mental acts, the mind of the entrepreneur, from which profits ultimately originate. Profit is a product of the mind, of success in anticipating the future state of the market.

Are profits reward for risk taking?

By some commentators, entrepreneurial profit is a reward for risk taking. The greater the risk the larger the profit, or so it is held. We suggest that profit emerges because entrepreneurs have successfully anticipated consumers’ demands for goods and services. Entrepreneurs are considering entering a particular line of business because their analyses indicate that they are likely to make profit by entering a particular business venture. The so-called risk is likely to be of a secondary consideration. If an entrepreneur concludes that, a particular venture is going to generate good profit he is going to mobilize the necessary means to accommodate future consumers’ needs to secure profit.  Hence, contrary to popular thinking profit is not the result of more risk but because businesses abide by consumers’ wishes.

In the words of Ludwig von Mises

A popular fallacy considers entrepreneurial profit a reward for risk taking. It looks upon the entrepreneur as a gambler who invests in a lottery after having weighed the favorable chances of winning a prize against the unfavorable chances of losing his stake. This opinion manifests itself most clearly in the description of stock exchange transactions as a sort of gambling. 

Mises then suggests, 

Every word in this reasoning is false. The owner of capital does not choose between more risky, less risky, and safe investments. He is forced, by the very operation of the market economy, to invest his funds in such a way as to supply the most urgent needs of the consumers to the best possible extent. 

Mises then adds, 

A capitalist never chooses that investment in which, according to his understanding of the future, the danger of losing his input is smallest. He chooses that investment in which he expects to make the highest possible profits.  

Again, for a businessman the ultimate criteria for investing his capital is to employ it in those activities which will produce goods and services that are on the highest priority list of consumers. Within all other things being equal, profit is the manifestation of the expansion in the pool of real wealth and hence the pool of real savings. 

Also, profit and loss are the instruments by means of which consumers pass the direction of production activities into the hands of those who are best fit to serve them.  Hence policies that undertaken to curtail or to confiscate profits impair this function. 

Are Profits Random?

It is widely held that financial asset markets fully reflect all available and relevant information, and that adjustment to new information is virtually instantaneous. This way of thinking also known as the Efficient Market Hypothesis (EMH), and is closely linked with the Rational Expectations Hypothesis (REH). 

The REH postulates that market participants are at least as good at price forecasting as is any model that a financial market scholar can come up with, given the available information. 

Changes in asset prices occur because of news, which cannot be predicted in any systematic manner. Asset prices respond only to the unexpected part of any news, since the expected part of the news is already embedded in prices. The implication of the EMH is that any analysis of past data is of little help since whatever information this analysis will reveal is already embedded in asset prices.

The proponents of the EMH hold that the main message of their framework is that excessive profits cannot be secured out of public information. They maintain that any successful method of making profits must ultimately be self-defeating. The EMH proponents even maintain that a dart-throwing chimpanzee can be a good substitute for entrepreneurial activity. What this approach suggests is passivity and resignation from an active search for opportunities. 

We suggest that the recognition of the existence of potential profits means that an entrepreneur had a particular knowledge that other individuals did not have. Having this unique knowledge means that profits are not the outcome of random events, as the EMH suggests.

Again, for an entrepreneur to make profits, he must engage in planning and anticipate consumer preferences. Planning and research never guarantee that profit will be secured. Various unforeseen events could upset entrepreneurial forecasts. Uncertainty is part of the human environment, and it forces individuals to adopt active positions, rather than resign to passivity, as implied by the EMH. 

Conclusions

Some commentators are of the view that profit is the outcome of exploitation of some individuals by some other individuals. 

Hence, anyone who is seen as striving to make profits is regarded as the enemy of the society and must be stopped in time from inflicting damage because of exploitation.

Profit however, has nothing to do with exploitation. It is an indicator as it were whether real savings were employed in the best possible way, as far as promoting individuals’ life and wellbeing is concerned.

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