Mr. Summers is a member of the staff of the Foundation for Economic Education.
According to popular opinion, profits raise the cost of living. Yet there have been times—particularly in the period before World War I—when many businesses earned high profits while the cost of living was falling. Before the last businessman is hanged in effigy, let us give the matter some thought.
Prices, of course, are determined by supply and demand. If the supply of a product is high and/or the demand is low, the price will be low. If the supply is low and/or the demand is high, the price will be high.
Profits (and losses) are the difference between selling prices and costs of production. Because a merchant usually can do little to alter supply and demand—and hence influence selling prices—efficient production is the main source of profits.
Profits can affect prices only by affecting the two factors that determine prices: supply and demand. Let us consider each in turn.
Demand is determined by consumer preferences and the amount of money consumers have to spend. Business profits have little effect on either of these factors, but the total amount of money people have—the nation’s money supply—is controlled by the Federal government. For several decades it has been Federal policy to run up deficits and make up the difference by increasing the quantity of money. This has effectively increased consumer demand and raised the cost of living.
Supply is determined by manufacturers’ willingness and ability to produce. Businessmen are willing to produce when they have the opportunity to earn profits. They are able to produce when the opportunity to earn profits attracts investment from outside sources and/or when profits are available from reinvestment.
Thus, in the long run, profits stimulate increased supplies and tend to reduce the cost of living. But, in recent decades, this tendency has been overridden by the federal government’s deficit spending. We will not see a decreasing cost of living until the federal government balances its budget and removes the shackles it has placed on production.