Another repost from my website.
The real story behind profit
by Isaac Crawford
The concept of profit is a nebulous and contentious one with many people. Ideas such as “profit is exploitation” and “profit is never earned” are very common, but they show a real ignorance of what it is and what it accomplishes.
One reason for this is the confusion between what accountants and economists consider profit. Economists usually trumpet the virtues of profit, but everyone thinks of accounting profit. What they see is how someone else (perhaps their employer) gets a “profit” and the company got it through their hard work! Surely this is unfair, if someone does the work, they should get the “profit” from that effort.
To understand what economists call “profit”, let’s look at why the worker continues in this “unfair” arrangement. The worker needs money for a variety of reasons, so work will be required (we’re going to ignore government hand outs for the time being). He looks at the available jobs, applies for some, and some of them offer to hire him. Let’s look at some hypothetical examples of job offers:
1) The first job offers him a yearly salary of $27,000. It is a fairly undemanding (for him) job, regular hours, no overtime, and is close to where he lives.
2) The second job offers him a position that pays $52,000 a year. It is a management position and there are a lot of responsibilities and pressures. It is also requires a bit of a commute.
3) The third job pays $107,000 a year. He would be a company rep, traveling extensively (3 1/2 weeks a month), endless meetings, phone time, and will require 60-70 hour weeks in order to get everything done.
4) The fourth job is a commission one. There is no guaranteed pay, but people are earning anywhere between $40,00-$450,000 a year. Like all commission jobs, there are long hours, and there is a lot of effort required in order to make a living. The best performers are putting in 60-70 hours a week and put up with endless rejections and abuse from so-called leads.
So which job does he take? Here’s where the concept of economic profit comes into play. Obviously, the money that each job offers is only one of the criteria that the worker has to think about when trying to choose a job. When you are in the accounting mindset, the only thing that matters and is counted is the money. Everyone engages in economic reasoning even if they don’t realize it. Cost benefit analysis is the technical jargon for what happens. The worker weighs the amount of the benefit (in this case we’re assuming that it is mostly the salary and what it will allow him to do) vs. what it will cost him. Economic cost (or opportunity cost) is the next best thing you give up in order to get whatever it you want. For example, if the worker values time with his family, he will have to weigh the “cost” of seeing them less for more money. Obviously, there isn’t a way to quantify that exactly, but we can get a rough idea of how much he values it by the choice he makes.
If he picks the traveling rep job, it is obvious that he values the $107,000 more than time with his family. On the other hand, if he picks the management job, it becomes clear that he values the time with his family at more than $107,000 a year. This is called revealed preference, and it is a powerful way of seeing how people actually value things as opposed to how they say they value them. There are endless situations and personal reasons for picking any particular combo of costs and benefits. Imagine if the guy hates his wife but can’t divorce her, cannot stand commuting to point of it affecting his blood pressure and health, has a child that needs specialized (and expensive) medical care, has a child that has very time intensive needs (retardation, handicap, etc.), or any number of other situations that could make him choose one job over the other. There is no way to know what kind of decisions people face, so it is best to allow them to make the decisions that are best for them.
So the worker makes his choice. His economic profit consists of the benefits he receives vs. the cost he incurs. The salary is a big part of that, but do not get too hung up on the numbers. What is important is what he will do with the money, not the money itself. He works in order to do these things, not to make money. Other things that may also be a benefit include liking the job, having a sense of accomplishment, prestige, power, etc. The costs are spread across the time spent, aggravation, time away from the family (although this could be a benefit for some), stress, etc. The biggest cost is what else he could be doing. This is what is being given up in order to work at the job, it is the opportunity cost. As long as the worker thinks the job is “worth it” and there is nothing better that he can do, he will continue in the job. He feels that he is getting more than he giving up.
This does not mean that the worker loves, or even likes his job. It only means that he feels that he is getting as much benefit out of a job as he thinks he can get. Obviously, the more “profit” he gets, the more likely he is to like his job. This can happen by lowering of the costs (less stress, shorter hours, shorter commute, etc.), raising the benefits (more money, more prestige, etc.) or a combination of the two.
That is a long winded way of saying that workers profit from having a job. The nature of this profit can be seen by observing what the worker can do (or feels in a positive aspect) with the job that he couldn’t without it. if there were no profits to be had, if the job cost more than what he would get, he would stick with the “normal” unemployed condition. A job that had no economic profit in it would make him worse off than having no job at all.
OK, that is all well and good, but c’mon, the company still makes money off of the worker. That still isn’t “fair.” With people, profit can take all sorts of forms, a nicer home, a new car, sending the kids through college, not starving, etc. Companies take profit in one form only, money. Just as the worker will not work if there is no profit for him, the company will not employ someone if there isn’t any benefit to them. It’s pretty simple, each side has to profit in order for the transaction to take place.
The interesting thing is that there are opposing forces at work. Each side wants as much profit as it can get. Sometimes there is no agreement to be had. The company cannot hire (or continue to employ) someone and achieve the profit that they want. The employee is not willing to go as low as the company wants. The worker can go look for another job. The company has four options:
1) Accept lower profits.
2)”Outsource” the labor to a place that has lower labor costs. This could mean moving the work from Dearborn to the Philippines or from Dearborn to Tennessee.
3) Invest in machines (capital) that can do the job instead.
4) Go out of business.
Just as with workers, companies have various reasons to want/accept certain levels of profit. Pressure from stock holders, trying to attract investors, or just wanting a good return on the money you are putting on the line are all common reasons for picking a profit point. It is important to understand that option #4 is always available, and a company would rather be “unemployed” than to operate in a way that brings in a negative profit, or a profit that is less than the alternative use of the money on the line (opportunity cost again).
There are many people that think that things are often skewed so that the company profits (in all ways) much more than the employees. This is most noticeable in developing countries. The thing to keep in mind is that the workers are still enjoying a profit, if they didn’t they wouldn’t work there. Along the same lines, if they thought they could do something else with more profit in it, they would do that instead. In short, the company is offering them their best alternative. Remember, there has to be profit on both sides for the exchange to happen. If a company is facing the decision of where to open a plant, it will go with the place that, all things considered, will maximize the profit for the company. The workers pick what will maximize their profit and the company does the same. While some may feel outrage that there is more profit on one side than the other, remember that we are talking about profit. In the places where this sort of thing happens the most, the people are happy to be able to profit at all. Development economics is complicated (if it wasn’t, we wouldn’t see so much poverty around the world), but this is the very very short version of how things improve even when there is a great disparity of profits at the beginning. The basic idea is that even if the company takes all of its profits back home, the people working have to do something with their profits. They will purchase things, so people have to provide those things. The profits from the first job lead to profits in another and then another… I will devote another essay to this, but for now take my word that profit begets more profit. It is a process that takes time. But as long as we are talking about profits, everyone (company and workers) are made better off.
The same concepts hold true when the situation is reversed. When a consumer is trying to decide whether to buy something or not, they weigh the cost and the expected benefits. If they think the product is “worth” the price, they will buy it. That is, if they feel that the benefit is worth what they have to pay, they will pay the cost in order to enjoy that profit. For those of you that are still stuck on the idea that it is “unfair” that a company makes a profit off of the labor supplied, let me ask you this. Is it fair that someone can pay $800-$900 for a really nice set of pots and pans for a kitchen and use them to run a successful restaurant? Those pots and pans may generate $30,00-$40,000 (or more) and yet the company (and indirectly the workers) only got $900! There are endless examples of consumers buying a product and benefitting tremendously in the financial sense. Cars, tools of all sorts, haircuts, clothes, they can all lead to better financial outcomes for the consumers that buy them, is that fair? Should we try to even everything out?
That would be a bad idea. You see, everything that is bought or made, every job that is performed, every service rendered, is all done for the sake of economic profit, or at least the potential for it. If we limit or try to lessen the amount of profit made by anyone, workers, consumers, companies, we will have far fewer options. In addition, all innovations and new inventions have profit as their primary motive. With a little thought, it will be easy to see why any sanctions to “punish” companies enjoying “excess” profits will also punish workers and then consumers. Successful companies are the source of employees’ profits, and the products that the two of them produce are the source of consumers’ prfoits. In the big picture, all of these categories are the same. Every company is a consumer, every worker is a producer, and every consumer is an employer. You cannot affect one without affecting the others. If you look at countries that limit profit through taxation and other government meddling, you will see far less innovation. When was the last time you heard of anything new coming out of France?
Profit is what makes things go, it is the reward for offering products, labor, or satisfying a demand. Without profit, or the chance of profit, we have few products, no jobs, and little happiness. Without the possibility of a good profit, why would people ever risk the money they had in order to make a new product? Why would companies try to fill the gap when there is a want that is not being fulfilled in the market? Why would anyone work when they could sit around the fire and enjoy the great outdoors all year long? Economic profit is necessary, without it, nothing happens. It is difficult to ascribe a definite good/bad label on accounting profit, but economic profit is unambiguously good for both the immediate beneficiaries and society as a whole.