The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups. -Henry Hazlitt, Economics in One Lesson, 1946

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Monday, September 28, 2009

EIOL The Function of Profits

Economics in One Lesson by Henry Hazlitt

The function of profits

The indignation shown by many people today at the mention of the very word "profits" indicates how little understanding there is of the vital function that profits play in our economy. To increase our understanding, we shall go over again some of the ground already covered in Chapter XV on the price system, hut we shall view the subject from a different angle.

Profits actually do not bulk large in our total economy. The net income of incorporated business in the fifteen years from 1929 to 1943, to take an illustrative figure, averaged less than 5 per cent of the total national income. Yet "profits" are the form of income toward which there is most hostility. It is significant that while there is a word "profiteer" to stigmatize those who make allegedly excessive profits, there is no such word as " wageer"--or "losseer." Yet the profits of the owner of a barber shop may average much less not merely than the salary of a motion picture star or the hired head of a steel corporation, but less even than the average wage for skilled labor.

The subject is clouded by all sorts of factual misconceptions. The total profits of General Motors, the greatest industrial corporation in the world, are taken as if they were typical rather than exceptional. Few people are acquainted with the mortality rates for business concerns. They do not know (to quote from the TNEC studies) that "should conditions of business averaging the experience of the last fifty years prevail, about seven of each ten grocery stores opening today will survive into their second year; only four of the ten may expect to celebrate their fourth birthday." They do not know that in every year from 1930 to 1938, in the income tax statistics, the number of corporations that showed a loss exceeded the number that showed a profit.

How much do profits, on the average, amount to? No trustworthy estimate has been made that takes into ac- count all kinds of activity, unincorporated as well as incorporate business, and a sufficient number of good and bad years. But some eminent economists believe that over a long period of years, after allowance is made for all losses, for a minimum "riskless" interest on invested capital, and for an imputed "reasonable" wage value of the services of people who run their own business, no net profit at all may be left over, and that there may even be a net loss. This is not at all because entrepreneurs (people who go into business for themselves) are intentional philanthropists, but because their optimism and self- confidence too often lead them into ventures that do not or cannot succeed.*

It is clear, in any case, that any individual placing venture capital runs a risk not only of earning no return but of losing his whole principal. In the past it has been the lure of high profits in special firms or industries that has led him to take that great risk. But if profits are limited to a maximum of, say, 10 per cent or some similar figure, while the risk of losing one's entire capital still exists, what is likely to he the effect on the profit incentive, and hence on employment and production? The wartime excess profits tax has already shown us what such a limit can do, even for a short period, in undermining efficiency.

Yet, governmental policy almost everywhere today tends to assume that production will go on automatically, no matter what is done to discourage it. One of the greatest dangers to production today comes from government price-fixing policies. Not only do these policies put one item after another out of production by leaving no incentive to make it, hut their long-run effect is to prevent a balance of production in accordance with the actual demands of consumers. If the economy were free, demand would so act that some branches of production would make what government officials would undoubtedly regard as "excessive" or "unreasonable" profits. But that very fact would not only cause every firm in that line to expand its production to the utmost, and to re- invest its profits in more machinery and more employment; it would also attract new investors and producers from everywhere, until production in that line was great enough to meet demand, and the profits in it again fell to the general average level.

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 he made, and in what quantities-and what articles will not he 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 he used up in making the article is greater than the value of the article itself.

One function of profits, in brief, is to guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand. No bureaucrat, no matter how brilliant, can solve this problem arbitrarily. Free prices and free profits will maximize production and relieve shortages quicker than any other system. Arbitrarily- fixed prices and arbitrarily-limited profits can only pro- long shortages and reduce production and employment.

The function of profits, finally, is to put constant and unremitting pressure on the head of every competitive business to introduce further economies and efficiencies, no matter to what stage these may already have been brought. In good times he does this to increase his profits further; in normal times he does it to keep ahead of his competitors; in bad times he may have to do it to survive at all. For profits may not only go to zero; they may quickly turn into losses; and a man will put forth greater efforts to save himself from ruin than he will merely to improve his position.

Profits, in short, resulting from the relationships of costs to prices, not only tell us which goods it is most economical to make, but which are the most economical ways to make them. These questions must be answered by a socialist system no less than by a capitalist one; they must be answered by any conceivable economic system; and for the overwhelming hulk of the commodities and services that are produced, the answers supplied by profit and loss under competitive free enterprise are incomparably superior to those that could be obtained by any other method.