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.