The Ethics of Profit Making
AUGUST 01, 1979 by BRIAN SUMMERS
Mr. Summers is a member of the staff of The Foundation for Economic Education.
Defenders of profit making almost invariably use one or more standard arguments. Let us examine the strengths and weaknesses of these arguments—and then consider a new approach which throws additional light on the ethics of profit making.
A businessman’s profits (or losses) are his net revenues minus the market value of whatever labor he put into the business and minus whatever interest he passed up by investing his own capital in the business. Thus, if a businessman could have earned $20,000 a year doing the same work for someone else, and if he had $50,000 invested in the business when the market rate of interest was 10 per cent, he made a pure (entrepreneurial) profit only if his net revenues for the year exceeded $25,000.
If a businessman does make a profit, he may try to justify it by pointing out that he has invested his own capital in the business and patiently waited for his return. But implicit interest (in our example $5,000) is excluded, by definition, from profits. Profits are not a reward for waiting; interest is a reward for waiting.
Or the successful businessman may declare that he has worked hard—that his profits are the "fruit of his own labor." But, by definition, implicit wages ($20,000 in our example) are excluded from profits. Profits are not a reward for pure labor; wages are a reward for labor. Businessmen who suffer losses despite great personal efforts, and businessmen who reap profits with no more "labor" than a few telephone calls, illustrate the difference between profits and wages.
A similar argument asserts that profits are a reward for bearing risks. But businessmen who suffer losses also take risks. So do gamblers and mountain climbers. Should these people be rewarded just for bearing risks?
The risk argument is especially weak in the case of profits that are completely unexpected—windfall profits. A storm may pollute a town’s water supply, enabling the owner of a natural spring to reap windfall profits. The owner may have paid almost nothing for the spring, thus risking very little capital. It is difficult to justify his profits solely on the basis of his taking a risk.
In fact, the less capital a businessman invests in his business, the less implicit interest he loses and, other things being equal, the greater his profits. That is, other things being equal, the less capital risked, the greater the profits. Similarly with the businessman’s labor. The less effort he risks on a business, the less his implicit wages and, other things being equal, the greater his profits. In this sense, profits can result from not risking too much capital or labor.
If profits are not a "reward" for waiting, laboring, or bearing risks, the defender of profits must seek other arguments. He often turns to the free market economist, who usually provides a utilitarian argument.
The economist points out that competition leaves businessmen little choice but to charge whatever price the market is paying. Thus, the prime way to earn profits in a market economy is to cut costs through the prudent use of scarce factors of production. The businessman who conserves the most resources, while giving consumers the most for their money, earns the greatest profits. Profits and losses promote efficient production; free market prices eliminate shortages and surpluses; profits provide the incentive and means to invest in productive capital goods. The utilitarian argument can be very compelling.’
Furthermore, the utilitarian argument offers a defense for windfall profits and speculative profits. In the case of windfall profits, suppose a disaster destroys much of a city’s housing. In a free market, rents will rise—encouraging people to take in boarders, share apartments, bring in portable shelters, repair damaged housing, and build new dwellings. Thus, profits will encourage people to alleviate the housing shortage, so that rents will soon fall back to "reasonable" levels. Of course, if rent controls prohibit windfall profits, this natural recovery will be stifled.
The utilitarian argument also offers a defense for the profits of commodity speculators and land speculators.2 Commodity speculators buy when they expect a shortage—encouraging increased production and conservation. They sell when they expect a surplus—discouraging further production and encouraging increased use of the commodity. Thus, commodity speculators tend to smooth out shortages and surpluses. In addition, they quote future prices which tend to reduce the uncertainty facing businessmen, farmers, and consumers.
Land speculators earn profits by buying property for which no one else sees much use, and later selling it to someone who recognizes the property’s high yield potential. Thus, land speculators keep property out of low productive uses and store it up for high productive uses.
Paul A. Samuelson challenges this utilitarian approach by pointing out that a speculator may, for instance, learn of a crop failure only a few seconds before his competitors and thereby reap huge profits. He finds it difficult to justify these profits solely on the basis of the few seconds the market gains in adjusting to the crop failure.
But Samuelson ignores the role of incentives. It is true that if the first speculator didn’t learn of the crop failure, others might have learned a few seconds later. But it is not necessarily true that these other speculators would have acted as quickly (or acted at all) without the profits that awaited the "winning" speculator.3
The utilitarian argument offers a formidable defense for profits earned in a free market system—based on the economic efficiency of the system itself. Yet many people are not satisfied by this argument. They may be willing to trade some economic efficiency for other goals, such as a proposed "fairer" distribution of wealth.
Some businessmen try to counter these proposals by asserting that their profits are too small to warrant much reduction. This may be true, but the utilitarian argument shows that the small profits of some are no reason for taxing the large ("excess") profits of others. In fact, other things being equal, the maker of small profits has used up more scarce resources than the maker of large profits. On utilitarian grounds, large profits are more commendable than small profits.
Voluntary Transaction Argument
To effectively counter objections to the utilitarian argument, defenders of profit making may turn to more philosophical arguments. They may, for instance, point out that in a free market all profits and losses are the results of voluntary transactions. In a free society, no one is coerced into dealing with a particular businessman. Each person enters into a transaction expecting to improve his own condition—otherwise he wouldn’t trade.
To the libertarian, this argument carries much weight. Who can condemn a voluntary trade? Yet many people do. They point out that prostitutes, pornographers, and drug dealers often engage in voluntary transactions; yet these transactions, for other reasons, are to be condemned. Until people place a higher value on freedom, the voluntary transaction argument will fail to satisfy many critics of profit making.
Property Rights Argument
Another philosophical argument is based on property rights. The businessman either owns a good or has hired the factors of production used to produce it. Therefore, once his employees, suppliers, creditors, and landlord have been paid, any implicit wage, implicit interest, or profit remaining from the sale of his good rightly belongs to him.
This argument can be used to justify any profit made in a free market. It is, however, based on the sanctity of private property. Those who use this argument must be prepared to defend the right to private ownership.4
Even for those who believe in private ownership, the property rights argument creates the impression that the businessman purchases factors of production and then just sits back to (hopefully) collect his profits. Many people are dissatisfied with this approach because they feel that a person should actively do something to deserve a profit. The fact that the businessman may have labored does not overcome this objection because, as we have seen, implicit wages are excluded from pure profits. Something seems to be missing from the property rights argument.
What is missing is a recognition that the entrepreneur creates the opportunity to discover his profits. This new approach to the ethics of profit making, based on the seminal writings of Israel M. Kirzner,5 does not, of course, claim that the entrepreneur physically creates his products. Products are physically "created" (transformed from one form into another) by workers using the capital goods investors provide them. But workers and investors don’t decide what product to make and which factors of production to use. The entrepreneur makes these decisions. His decisions determine which product will be offered to consumers and what the costs of production will be (calculated from the market prices of the factors of production he chooses). The entrepreneur’s decisions make the difference between profit and loss.
Thus, although a businessman may not physically create his products (although by the property rights argument he owns them), he does create the opportunity to discover if consumers will pay a price which exceeds his costs. An illustrative example is the speculator who buys a good and then sells the physically unchanged good at a profit. By purchasing goods and offering them for sale, speculators create their own opportunities to discover profits.
This approach casts additional light on Samuelson’s speculator who learns of a crop failure a few seconds before his competitors. Previously we saw how his profits can be justified on utilitarian grounds. They are also justified by the voluntary transaction argument and the property rights argument. But now we see a new justification for his profits. By placing purchase orders a few seconds before his competitors, he creates his opportunity to discover profits. He alone creates his opportunity, so any profit or loss is his.
Note that this is not simply a "finder-keeper" argument. The entrepreneur doesn’t merely discover his profit, like a child stumbling across a bright pebble. Even the reaper of windfall profits must first acquire title to property before he can sell it at a profit. By acquiring property, the entrepreneur creates his opportunity to discover if he can sell it at a profit.
Nor is this a "creator-keeper" argument. In a competitive market, with no governmentally imposed barriers to entry, a businessman cannot set his price by arbitrarily adding a "profit" to his costs (as government-created monopolies and cartels can do). In a competitive market businessmen must discover what prices consumers will pay. Thus, this approach to the ethics of profit making is perhaps best labeled a "creator-finder-keeper" argument.
So far we have considered the profits and losses of a businessman operating in a free market. But the real world contains partnerships and corporations in addition to sole proprietorships. Also, the real world is by no means a free market—it is a market increasingly hampered by government interventions. How do the various arguments used to justify profits apply to the real world?
Partnerships and Corporations
Partnerships and corporations, historian Robert Hessen has shown, are networks of contractual relationships.6 Thus, the voluntary transaction argument can be directly applied to justify the profits of these forms of business. The utilitarian argument is directly applicable by simply changing the word "businessman" to "partnership" or "corporation." For the property rights argument we change "businessman" to "partners" or "stockholders."
The creator-finder-keeper argument can also be applied to partnerships and corporations. Somewhere in the business organization decisions are made as to what to produce and show to produce it. For the creator-finder-keeper argument it doesn’t matter where in the organization these decisions are made. It suffices that profit opportunities are created by the business. Thus, when it is discovered that consumers will pay a profit-yielding price, the profits belong to the partnership or corporation and are apportioned among the members according to contractual agreements.
But what about profits earned in a market hampered by government intervention? The arguments we have considered justify a businessman’s profits only to the extent that his profits do not derive from interventions. The more the government intervenes in the economy, the less likely it is that these arguments will apply.
This is clearly the case with the voluntary transaction argument.
The more the government intervenes, the more do transactions become involuntary. For instance, the beneficiary of an import quota may claim that customers "voluntarily" patronize him. But they may patronize him only because the quota prevents them from dealing with foreign businesses.
The utilitarian argument also becomes less applicable the more the government intervenes. In a free market, businessmen earn profits through the efficient use of scarce resources. Their profits are the result of using as little as possible to provide consumers with as much as possible. The more the government intervenes, however, the less profits reflect efficiency, and the more they reflect politically determined prices. For example, a land speculator may reap profits, not by finding a buyer who recognizes the productive potential of his land, but through a zoning change.
The property rights argument is also vitiated by government intervention. The more the government is used as an instrument for violating private property rights, the less appropriate this argument becomes. For instance, the recipient of a government subsidy can hardly justify his profits by appealing to private property rights when those around him are paying taxes on their property to finance his subsidy.
The same holds for the creator‑finder-keeper argument. The creator of a profit-yielding opportunity cannot use this argument to justify his profits when the opportunity has been politically created. Businessmen who successfully lobby for subsidies, tariffs, restrictions on competitors, and other government favors create profit opportunities for themselves by restricting the opportunities of their fellow men.
This brief essay has not, of course, completely spelled out any of the arguments used to justify profits. Nor has it considered all the arguments. Left untouched, for instance, are Biblical justifications, profits from immoral and/or illegal activities, and the basic question of the morality of the private property system.
Nevertheless, we have seen that strong arguments can be brought forth in defense of profit making in a free market. The strengths of these arguments, in fact, suggest that businessmen spend less time apologizing for their profits and spend more time challenging their tormentors to justify the ethics of price controls, "excess" profits taxes,union coercion, and other interferences with the peaceful conduct of business.
‘The best example is Ludwig von Mises’ "Profit and Loss" in Planning for Freedom (Libertarian Press, South Holland, Illinois, 1952).
2See "Why Speculators?" by Percy L. Greaves, Jr. (The Freeman, November 1964) and "Those Fellows with Black Hats—the Speculators" by John A. Sparks (The Freeman, August 1974).
3Israel M. Kirzner, Competition and Entrepreneurship (University of Chicago Press, 1973) pp. 223-225.
‘This can be done on several grounds, but is beyond the scope of this essay. See, for instance, Samuel L. Blumenfeld, editor, Property in a Humane Economy (Open Court, LaSalle, Illinois, 1974) and Gottfried Dietze, In Defense of Property (The Johns Hopkins Press, Baltimore, 1971).
5See his Competition and Entrepreneurship (University of Chicago Press, 1973) and Perception, Opportunity, and Profit (University of Chicago Press, 1979, forthcoming) especially chapters 11 and 12 of the latter. There are, however, several points of difference in our analyses; any errors in this paper are entirely my responsibility.
‘,Robert Hessen, In Defense of the Corporation (Hoover Institution Press, Stanford, California, 1979).
Ludwig von Mises
There is in the market economy no other means of acquiring and preserving wealth than by supplying the masses in the best and cheapest way with all the goods they ask for.