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Friday, April 18, 2008

The Role of Profit

Here are a few different takes:

At least when a society has the appropriate institutions and government policies, the overwhelming majority of the firms that make huge profits are doing a huge service to the population. In a society with the right institutions and public policies, the prevailing prices will approximate the true values and costs of marginal quantities of the goods and productive inputs. A great excess of revenues over costs means that the enterprise is almost certainly putting more value into the society than it is taking out.
Mancur Olson (scroll down at link)

What intellectuals steeped in constructivist presuppositions find most objectionable in the market order, in trade, in money and the institutions of finance, is that producers, traders, and financiers are not concerned with concrete needs of known people but with abstract calculation of costs and profit. But they forget, or have not learned, the arguments that we have just rehearsed. Concern for profit is just what makes possible the more effective use of resources. It makes the most productive use of the variety of potential support that can be enlisted from other business undertakings. The high-minded socialist slogan, 'Production for use, not for profit', which we find in one form or another from Aristotle to Bertrand Russell, from Albert Einstein to Archbishop Camara of Brazil (and often, since Aristotle, with the addition that these profits are made `at the expense of others'), betrays ignorance of how productive capacity is multiplied by different individuals obtaining access to different knowledge whose total exceeds what any single one of them could muster. The entrepreneur must in his activities probe beyond known uses and ends if he is to provide means for producing yet other means which in turn serve still others, and so on – that is, if he is to serve a multiplicity of ultimate ends. Prices and profit are all that most producers need to be able to serve more effectively the needs of men they do not know. They are a tool for searching – just as, for the soldier or hunter, the seaman or air pilot, the telescope extends the range of vision. The market process gives most people the material and information resources that they need in order to obtain what they want. Hence few things are more irresponsible than the derision of concern with costs by intellectuals who, commonly, do not know how to go about finding out how particular results are to be achieved at the least sacrifice of other ends. These intellectuals are blinded by indignation about that essential chance of very large gains that seem disproportionate to the effort required in a particular case, but that alone makes this kind of experimentation practicable.

It is hence hard to believe that anyone accurately informed about the market can honestly condemn the search for profit. The disdain of profit is due to ignorance, and to an attitude that we may if we wish admire in the ascetic who has chosen to be content with a small share of the riches of this world, but which, when actualised in the form of restrictions on profits of others, is selfish to the extent that it imposes asceticism, and indeed deprivations of all sorts, on others.
Hayek on profit (from The Fatal Conceit)...


I had been contemplating writing a short post about the role of profit for some time. Fortunately, Professor Steven Horwitz did such a nice job.

One of the more common complaints of critics of the market is that “the profit motive” works at cross-purposes with people and firms doing “the right thing.” The overarching problem with blaming a “motive” is that it ignores the distinction between intentions and results. That is, it ignores the possibility of unintended consequences, both beneficial and harmful.

What we care about is whether the goods get delivered, not the motives of those who provide them. Smith led economists to think about why it is that, or under what circumstances, self-interest leads to beneficial unintended consequences. It is perhaps human nature to assume that intentions equal results, or that self-interest means an absence of social benefit, as was often the case in the small, simple societies in which humanity evolved. However, in the more complex, anonymous world of what Hayek called “the Great Society,” the simple equation of intentions and results does not hold.

As Smith recognized, what determines whether the profit motive leads to good results are the institutions through which human action is mediated. Institutions, laws, and policies affect which activities are profitable and which are not. A good economic system is one in which those institutions, laws, and policies are such that the self-interested behavior of producers leads to socially beneficial outcomes. In mixed economies like that of the United States, the institutional framework often rewards profit-seeking behavior that does not produce social benefit or, conversely, prevents profit-seeking behavior that could produce such benefits. For example, if agricultural policy pays farmers not to grow, then the profit motive will lead to lower food supplies.

Labeling the profit motive as the source of the problem enables the critics to ignore the really difficult questions about how institutions, policies, and laws affect the profit-seeking incentives of producers and how that profit-seeking behavior translates into outcomes. Placing the blame on the profit motive without qualification simply overlooks the Smithian question of whether better institutions would enable the profit motive to generate better results and whether current policies or regulations are the source of the problem because they guide the profit motive in ways that produce the very problems the critics identify.

Placing blame for social problems on the profit motive is also easy if critics offer no alternative. What should be the basis for determining how resources are allocated if not in terms of profit-seeking behavior under the right set of institutions? How should people be motivated if not by profit? Often this question is just ignored, as critics are merely interested in casting blame. When it is not ignored, the answers can vary, but they mostly invoke a significant role for government. The implicit assumption, of course, is that the government personnel will not be motivated by profits or self-interest in the same way as the private-sector producers are.

How realistic this assumption is remains highly questionable. Why should we assume that government officials are any less self-interested than private individuals, especially when the door between the two sectors is constantly revolving? And if government officials do act in their self-interest and are motivated by the political analogs of profits (for example, votes, power, budgets), will they produce results that are any better than the private sector’s?

To blame the profit motive without asking whether an alternative will better solve the problems supposedly caused by the profit motive is to bias the case against the private sector.

Even this argument, however, does not go far enough. We are still, after all, focused on intentions and motivation. What critics of the profit motive almost never ask is how, in the absence of prices, profits, and other market institutions, producers will be able to know what to produce and how to produce it. The profit motive is a crucial part of a broader system that enables producers and consumers to share knowledge in ways that other systems do not.

For many critics of the profit motive, the problem is solved because public-spirited politicians and bureaucrats have replaced profit-seeking firms. Well, not so fast. By what method exactly will the officials know how to allocate resources?

In markets with good institutions, profit-seeking producers can get answers to these questions by observing prices and their own profits and losses in order to determine which uses of resources are more or less valuable to consumers. Rather than having one solution imposed on all producers, based on the best guesses of political officials, an industry populated by profit seekers can try out alternative solutions and learn which ones work most effectively. Competition for profit is a process of learning and discovery.

Thus the real problem with focusing on the profit motive is that it assumes that the primary role of profits is to motivate (or in contemporary language “incentivize”) producers. If one takes that view, it might seem relatively easy to find other ways to motivate them or to design a new system where production is taken over by the state. However, if the more important role of profits is to communicate knowledge about the efficiency of resource use and enable producers to learn what they are doing well or poorly, the argument becomes much more complicated. Now the critics must explain what in the absence of profits will tell producers what they should and should not do. Eliminating profit-seeking from an industry doesn’t just require that a new incentive be found but that a new way of learning be developed as well. Profit is not just a motive; it is also integral to the irreplaceable social learning process of the market.

Regardless of which explanation resonates best with you, it is vital to grasp the role of profit in order to better understand the functioning of a free market system.

Update: Liberty Lover weighs in:
...government managers have different incentives then private sector managers. They manage for the approval of politicians and other government employees rather than for profit and customers. For another thing, they have distorted information about what to produce, how much, which people should do what, and which resources should be allocated. Price controls hide these signals. Prices indicate the relative scarcity, demand, and supply of things.

41 comments:

Harry Eagar said...

Ah, yes, Adam Smith, who was never late for a meal, and who said that no one should be allowed to interfere with 'the inconvenience of dearth.'

His followers followed that advice and killed something like 50 million-80 million people.

Bret said...

How?

Harry Eagar said...

By moving food out of famine areas to places where it fetched a higher price.

See Woodham-Smith, 'The Great Hunger' and Davis, 'Late Victorian Holocausts'

Hey Skipper said...

Harry:

Taking all that as given, what better alternative is on offer?

Harry Eagar said...

Than taking food out of the mouths of people dying of starvation? Leave the food where it is.

I realize that Americans don't know nothin' about how free markets work, but Asians do and they haven't liked the results. Hence the bans on exports of rice from, eg, Vietnam.

The profit motive will work even where someone tries to suppress it. The problem is that when it is elevated to the status of deity, it works only too well.

That's why Roosevelt had to step in and save capitalism from itself.

I am working on a longer post on this at Restating the Obvious and may possibly have it up tonight.

Howard said...

Harry,

If I ignore: all of the damage from politically induced famines, all of the benefits from profit as a guide to much activity but not all -including as an inducement to produce more, our private not-for-profit sector and a government role that need not be large to be significant, The Theory of Moral Sentiments, the observation that some limited circles of people may deify profit but many more people vilify profit...if I ignore all of this and much more, then perhaps I might share your world view. I choose not to ignore these things.

Harry Eagar said...

Nobody I know is asking you to ignore any of those things.

I think you would be a better person, though, if you stopped ignoring millions done to death solely for the warm feeling of participating in a free market.

YMMV

aog said...

And instead start ignoring the many more millions of deaths caused by government intervention?

Harry Eagar said...

Non sequitur.

I have always found it curious how difficult most people find it to condemn all perps indiscriminately.

One suspects there may be a political angle behind their indignation.

aog said...

Mr. Eagar;

Yes, I don't understand at all why you fail to condemn government based failures the same way you condemn those of private entities. Most perplexing.

My comment alluded to the fact that your choices are interventionist governments or not, and while you condemn the results of non-intervention, you seem to give a complete pass to the even worse results of intervention. This leads you to create a straw man where the proponents of free markets ignore its undesirable results, when it's really the case that we view the results of non-free markets to be even worse, which we think the historical records bears out, particularly in the 20th century.

Harry Eagar said...

I don't agree that I fail to condemn government failures.

I confess to failing to condemn some alleged failures that were not failures: thus my antipathy to the likes of Amity Shlaes.

Bret said...

harry eagar wrote: "I don't agree that I fail to condemn government failures."

Yes, I agree that you have condemned government failures in general. For example, you're quick to identify when governments fail to intervene in virtually everything when you think they should.

However, it's much less often that you criticize any sort of failure of economic collectivism. For example, what do you think of Mao's "great leap forward"? Was that not a bad thing in your mind? Or do you somehow think that it was capitalism that caused those tens of millions to starve?

Adam Smith did not really say that "no one should be allowed to interfere with 'the inconvenience of dearth'". He stated that things are made worse, by "government attempting, by improper means, to remedy the inconveniences of a dearth." I'm sure he would've had no problem with private individuals or churches purchasing and distributing food to the hungry.

Harry Eagar said...

Maybe, but his followers did.

The Great Leap Forward was silly, OK.

I haven't seen a lot of people deifying the Great Leap Forward, though, while we have ignoranti like Liberty Lover making absurd statements about markets and prices: certainly what he said is not true about grain markets.

The idea that government-sponsored schemes are always bad and private ones are necessarily better is disproven by actual events, though it's true that it is almost impossible to find a market worshipper who knows much about actual events.

I like to cite the East African Ground Nut Scheme and Daniel Lykes' Amazon corn plantation as examples of parallel fairlures, one government, one private. I have never yet found a free marketeer who had ever heard of either one.

Howard said...

Harry,

Help me out. Your last comment gives the impression that you feel that you are rebutting a claim by free market advocates that, private enterprises are more likely to succeed and governmental ones to fail.

First, let me state that most things fail. What we see around us are the entities that have not yet failed. The far more numerous failures are gone from our obvious view. Private entities without access to tax revenue must either acquire new investment or eventually be self supporting through profit generation, or they will shortly cease to exist. Given appropriate institutions, a very important caveat, such profitability is a positive on a higher level. Under such an arrangement, a free market system is conducive to trying a greater variety of things and abandoning the many failures. This discovery process is a powerful engine of improvement.

Please clarify...is this a distinction being lost or do you have a different point?

aog said...

Mr. Eagar;

You're playing bait and switch here. You use examples from free market history to indict those who support free markets, even if they condemn the specific event you cite. Yet when discussing interventionism, something like the Great Leap Forward indicts only those who "deify" that specific event, not those who support the basic framework (interventionism) that created it. The net effect is that any free marketeer is tainted by any event in which free markets lead to a bad result, but interventionists aren't tainted by any event in which interventionism lead to a bad result. Naturally,free marketeers are going to look a lot worse in such a system of judgement, but it is because of that ideological structure which requires perfection of free markets but nothing, really, of interventionism except that it is not always the worse choice. This is precisely what I mean by your not condemning interventionism, the shrugging discard of any bad result.

This also leads to your strawman that "government-sponsored schemes are always bad and private ones are necessarily better". Our view is more akin to the claim that men are taller than women. Obviously untrue in every single case, but certainly the way to bet.

P.S. I have to say that I have never read any of the free marketeers here say something nearly as callous as you comment that the Great Leap Forward, with its 10 of millions of deaths, economic destruction, and ecological devastation as "silly". I think it's an archetypical example of my previous comment you labeled a non-sequitor. Or can we free marketeers dismiss your (far less disastrous and deadly) cited events as being "silly" as easily?

Harry Eagar said...

First, it isn't true that free market excursions into murder were less destructive than various socialist ones.

That's a myth that's shopped around a lot, but it's a myth.

I favor a mixed economy, since I've never seen an example of a successful market-based road network.

Whatever works is good and whatever doesn't work is bad. What's so difficult about that?

The idea that prices and markets are magically good is nonsense. Sometimes they work, sometimes they don't.

Examples of their not working: quinine, samphire, helium, sardines, grain.

Examples of government intervention working: highways, FHA, armies, fire prevention.

I could expand both lists more or less indefinitely.

aog said...

Can you name one that was as devastating as the Great Leap Forward?

joe shropshire said...

Whatever works is good and whatever doesn't work is bad.

Fair enough. How is the mixed market in grain working at the moment, and what ought to be done about that?

Harry Eagar said...

Sure, I already have: the Indian famine of 1876-78.

Or, taking the longer view, tsarism.

As for the grain market today, its problems are not recent and not addressable in any simple way.

A start would be to adopt the principle: food is food.

Until everybody is eating, diverting food for other purposes is a bad idea. (A lot of people have gone hungry over the last couple of centuries because arable was devoted to cotton; like I said, it's complicated.)

Here's an example of why it's complicated: the wheat yield per hectare in Afghanistan in 1 ton, in Kansas 6 tons, in France 15 tons.

Unlike, say, iPods, you cannot concentrate 100% of production in the 'most efficient' locale. 'Most efficient' doesn't have any real meaning when it comes to staple food.

The biggest bang for the buck in addressing staple food shortages would be to increase local yield averages. What Norman Borlaug did (and why I invented the World Food Prize, which I wrote about a little at Restating the Obvious last week, 'World Un-Food Anti-Prize' on April 21).

I haven't got enough information to tell which inputs are causing rising grain prices right now. Increased consumption of meat is one, diversion for fuel is one, slowing yield curves is one, and speculation is one.

Speculation is the one you guys need to tease out. What's so great about a system that produces profit by withdrawing food from starving people?

aog said...

No, it looks like the Great Leap Forward killed between 4 and 15 times as many people (Indian 1876 Famine ~5M, GLF ~20M to ~70M).

Tsarism? Seriously? I would think that was much more of a mixed system, which you favor. I do think it a bit disingenuous to attack free marketeers over systems that none of them consider free markets. Whatever it is they're supporting, it's not anything like Tsarism which had extremely regulated (unfree) markets. Is your definition of a free market one in which there exists at least one person who can do whatever he wants, regardless of restrictions on anyone else?

Harry Eagar said...

'Is your definition of a free market one in which there exists at least one person who can do whatever he wants, regardless of restrictions on anyone else?'

Bingo.

More precisely, in any free market, the one with the most money can do whatever he wants, while anyone with less money is correspondingly less free, down to the pauper who is free only to die.

Tsarism was a free market in the sense that food was taken from the starving and shipped to richer, foreign markets where the price was higher.

(There are other, higher estimates for the 1876-78 famine. Nobody was counting.)

aog said...

Then what's the point of arguing with us about that, since I doubt you could find a single one of us who promotes or "deifies" that? It's certainly not what any of the standard free market authors support either. You sound like OJ and his campaign against witchcraft.

Bret said...

Many discussions with Harry like these are at least partly about the definition of "capitalism" and "markets".

I absolutely agree that a system in which one person or a relatively small group of people own and/or control all or nearly all of the means of production of all or nearly all goods and services is not a good system. I call systems like that "feudal" or possibly "collectivist". Harry calls them "capitalist" and "free-market". I believe that Harry's definitions are complete distortions of the English meaning of those words and are terribly confusing, but at least at this point I understand enough Harry-speak to know what he means.

In addition, I don't think that any of the "free-marketeers" here think that there is never any role for government. Nobody here is an anarchist. I don't think anybody here would oppose government intervention in all cases of mass starvation. I certainly would not.

On the other hand, I might question the advisability of having governments managing food production or the production of other goods and services as the default case. I haven't been impressed, on average, of government managed economies. Harry, on the other hand, is much more impressed (apparently) with government managed economies. It's always a matter of subjective interpretation because we can never know how things would've turned out if different economic systems were used by various countries at various times. China might well have been a disaster even if Mao hadn't seized power. Life was no picnic under the Tzars in Russia - perhaps Stalin was no worse. Perhaps the U.S. would be heaven on earth if we had adopted communism. Even though India had a history of 1,000 years (maybe more) of cyclical famines prior to the arrival of the British, if it had adopted communism in 1,000 AD, maybe nobody would've died from hunger. Who knows? It's all impossible to prove one way or the other.

In about ten thousand years, we may have enough data to "prove" the validity of various economic ideas. Right now, no proof is possible. We all just have to go with our best guess.

Harry Eagar said...

Well, some alternative histories are more plausible than others. As the Belgian ambassador said to the German foreign minister on the outbreak of war in 1914: 'Whatever history says, she will not say that Belgium invaded Germany.'

Similarly, in all earlier famines, history will not say that the amount of foodstuffs exported from the death zones in India doubled because of free-market ideology.

Besides, I can go to 100 Liberty Street, throw out a bunch of golf balls and hit extremist free-marketers with every toss.

Here's a thought experiment. It is based on a real case.

You and your community depend for water on a small aquifer, which is just about adequate for the population. A billionaire moves in and decides he wants to use a lot more water than average and demands to be allowed to buy all the water from the municipal system that he wants. He is willing to pay more per thousand gallons than anyone else. He wants so much that if he gets as much as he wants, some other people will not have any (or, alternatively, everybody else will have less).

Well, let's ask Mr. Liberty Lover: What's wrong with that?

Bret said...

Who owns the aquifier and how did that entity come to own it?

BTW, who is "Mr. Liberty Lover" and where is "100 Liberty Street"?

aog said...

I do find it highly amusing that France under Louis XIV counts as "free market" according to Mr. Eagar.

joe shropshire said...

Well, if you're the people Harry is thinking about, you hang signs saying 'No to (name of billionaire's project)' on every other telephone pole in town. That'll show 'em. Of course, this is a community, if you want to call it that, that mostly bumps along on food stamps and crystal meth anyway, and the folks that might have gotten jobs out of it will scrape along somehow, or leave. Damn shame, Harry. Hell of a beautiful place, innit.

Harry Eagar said...

The community is Santa Monica, Calif. I don't think everybody there is on ice.

In Hawaii, water is not owned by anybody. It is held by the government in public trust. California may be different.

The billionaire in question was not building a project. He just wanted a nice green lawn in the desert. A really, really big lawn.

100 Liberty Street, New York City, is the address of the editorial offices of The Wall Street Journal, where you will find such uncompromising free marketeers as Amity Shlaes and Paul Craig Roberts.

No idea who Mr. Liberty Lover is, but he's like Shlaes and Roberts and was added approvingly to this post. Go figure.

It's amusing, Guy, but nevertheless apposite for all that. Stendahl had something to say about markets under the later Bourbons in 'The Red and the Black.' The chapter about firewood.

joe shropshire said...

Santa Monica? The median household income there is $60k. Not rich, but I don't think anybody's going to die of thirst there either. But I do beg your pardon anyway. I thought you were getting up on your soapbox about La'au Point.

Bret said...

Harry,

I thought it was going to be a thought experiment about people dying of thirst because of the rich dude. But no, since the people of Santa Monica mostly drink bottled water anyway, we're just talking rich dude waters his lawn while the less rich people have to let their lawns go brown. The horrors! The horrors!

In my opinion, your 1860s India famine was a much better thought experiment and I'm still thinking about it, especially in light of the current high food prices and its impact on the very poor.

In San Diego we have similar water problems, but instead of the rich dude, the villain is golf courses. There's public parks and school fields as well. But agriculture in the California desert uses over 80% of the water here. Rich dude and the rest of Santa Monica could have all the water they wanted at the same time if the farmers just stopped growing rice in the desert.

Harry Eagar said...

I said it was complicated, didn't I?

But the point is the same: If you decide beforehand that whoever has the most money gets to decide what happens, then you're no longer free.

In the Santa Monica case, the townspeople had decided to limit the amount of water any householder could use, because they wanted more households -- they didn't want one guy hogging it all.

Whether that's a good idea or not, it was arrived at openly and communally.

Bret said...

"If you decide beforehand that whoever has the most money gets to decide what happens, then you're no longer free."

Are you free if the majority decides what happens? If a select minority decides? What if the majority decides that you should work hard for no money? Are you still free? Or is that a type of slavery?

Harry Eagar said...

An eloquent demolition of democracy.

I'm not buying.

Bret said...

It's not a demolition of democracy. It's a question about whether or not even a democracy can be oppressive and limit freedom. You know, the tyranny of the majority thang.

If I personally steal from you or force you to do something under threat of violence, we'd agree that's a bad thing. If I and a friend of two or three or ten were to do that, we'd also agree it's a bad thing.

Yet if I and 200,000 of my closest friends do the same thing via this thing called government, it's okay.

Why?

That's a rhetorical question, but the point is that freedoms are limited in many ways, and in my opinion, those limitations are more often imposed by government, democratic or not, than by wealthy individuals.

Harry Eagar said...

That would be because you've only lived in a society with communtarian controls.

I live in one where people still remember, vividly and bitterly, living in the world you think you would like.

Bret said...

Where (or when) was that?

Howard said...

Bret,

Just realize that even though we've both expressed a preference for a mixed economy, anyone who asks questions about limiting the role of government seems to be an uberlibertarian in Harry's mind.

Bret said...

Yeah, I thought I was fairly libertarian until I got thrown out of Cafe Hayek for being too socialist.

Harry Eagar said...

Hawaii, up until the Revolution of 1954.

Bret said...

harry eagar wrote: "...living in the world you think you would like."

I've never said that I would like living in a place like Hawaii in 1900-1950. I would've left.

Let me repeat what I wrote in a comment above because you apparently missed it:

"I absolutely agree that a system in which one person or a relatively small group of people own and/or control all or nearly all of the means of production of all or nearly all goods and services is not a good system."

Harry Eagar said...

Well, then, let's hope that simpleminded New Deal remedies manage to prevent the collapse of the credit markets -- something the free market couldn't -- because if they don't, then it will turn out that a small number of (temporarily) wealthy people were able to control just about all the means of production.