Profit and Loss

Mr. Summers is a member of the staff of The Foundation for Economic Education.

When there is no understanding, emotions carry the day. We see this in mobs. We see this in war. And, sadly enough, if we will only stop to look, we will see this in ourselves and in our loved ones.

Some examples? There is no better place to look than economics, for while most people have strong feelings about economic issues, they lack an understanding of basic principles.

Many economic issues concern profit and loss. How do you feel about business profits and losses? Are profits bad? Why? And if profits are bad, are losses good? Why?

Most people have strong feelings about these questions. Unfortunately, they lack an understanding of the formation and function of profits and losses in a free market economy.

To gain an understanding, let us see how profits and losses come into being. Two neighbors—Mr. Able and Mr. Baker — start their own businesses. They borrow money at market interest rates, rent buildings at market rents, buy raw materials at market prices, and hire workers at market wages. A year later they sell their products —Able has made widgets while Baker has made wadgets — at market prices. When they examine their books, Able finds he has made a profit, while Baker finds he has sustained a loss.

What happened? Why didn’t Baker sell at a price that would have given him a profit too?

Well, he couldn’t. For if Baker had tried to sell at a price above the market price, his shelves would have remained full of unsold wad-gets. He would have had more wad-gets than buyers.

To see this, we need to understand free market pricing. In an unhampered market, the businessman adjusts his asking price so as to just sell all his products. If he tries to charge more than this optimum price, he loses so many customers to competitors that he can’t sell all his goods. If he charges less than this optimum price, the demand for his product exceeds his supply. With more would-be buyers than he can satisfy, he must resort to some form of rationing. Perhaps he will sell to just his friends.

Or perhaps he will raise his asking price to the market price. At the market price he can sell as many items as he wants, and customers can buy as many items as they want. At the free market price, there are no shortages and no surpluses.

The intelligent businessman is well aware of this. He knows he can’t make profits by simply raising his prices because he would lose his customers to the guy down the street. There is only one thing he can do — cut costs of production. Thus, the businessman tries to use his men and materials in the most efficient manner possible. And, because he must pay market wages, prices, and interest rates, he tries to minimize the number of men he employs, the amount of capital he uses, and the quantity of natural resources he consumes in producing his goods and services. In other words, he tries to practice conservation.

Most people are all for conserving natural resources. They understand that the natural resources Able doesn’t consume will be available for use by Baker or some other businessman. Unfortunately, they don’t understand that the same principle applies to labor and capital. The less labor and capital Able employs to produce his widgets, the more labor and capital is available to produce something else.

An inefficient producer — one losing money — uses large quantities of labor, capital, and raw materials to produce a given number of widgets. An efficient producer —one earning profits — uses less labor and/or capital and/or raw materials to produce the same number of widgets. The labor and capital that isn’t tied up in the production of widgets is free to help provide consumers with something else.

People say: "There is another possibility — Able may be making profits by paying his workers less than Baker."

In an unhampered market, workers who feel they are being exploited are free to seek other employers. Able needs workers; Baker needs workers; all businessmen need workers. In a free market there is no lack of employers because consumers are never satisfied. They always want more, better, and cheaper goods and services. In order to satisfy customer demands, businessmen need labor. They compete among themselves for workers’ services. An employer who tries to pay his workers less than market wages soon finds them going to other employers or pooling their resources to start their own businesses.

This raises an interesting point. Labor unions have accumulated hundreds of millions of dollars through compulsory dues. Their strike funds are large enough to sustain their members through months of idleness. Their pension funds are even bigger. If they truly feel their members are being exploited, why don’t they buy controlling interests in established corporations or start their own?

Others say: "Baker is losing money, so he can’t raise any capital. He may be inefficient, but his business is vital to the community. If his company fails, his workers will be thrown on the streets. These unemployed workers will have less money to spend, and all the local merchants will suffer. The government should keep Baker in business by making up his losses with a subsidy."

The government can only give to someone what it has taken from someone else. If the government gives Baker a subsidy, the taxpayers will lose precisely as much as Baker gains. Furthermore, the merchants who would have been patronized by the taxpayers will lose as much business as the merchants in Baker’s community gain. The wadget industry will be larger than it would have been in a free market, but other industries will be smaller. There will be no net gain.

In fact, there will be a net loss. Baker lost money because his costs of production were too high. He was inefficient. He used too much labor and/or capital and/or raw materials in producing his wadgets. If subsidized, he will have no reason to change his inefficient ways. If he isn’t subsidized, he will have to become more efficient or go out of business. If he does go out of business, his workers, capital, and raw materials will be released for use by other, more efficient businessmen.

Thus, subsidizing inefficient businessmen results in less production than would be the case without a subsidy. The standard of living is lowered. If at the turn of the century we had subsidized the horse-and-buggy trade, we would have slowed the growth of the automobile industry and all the jobs dependent on it.

While some people call for subsidies, others attack profits. Some would like the government to coerce Able into telling his workers: "Gentlemen, I have wonderful news. When I sold my widgets today, the market price was high. I am going to pay you all my profits. You will each receive a check forthwith."

Would these same people want Baker to tell his workers: "Gentlemen, I have terrible news. When I sold my wadgets today, the market price was low. You are going to pay me all my losses. You will each send me a check forthwith."

Of course, no one suggests the latter. Nor does anyone propose that Able pay bonuses to his landlord, creditors, or suppliers of raw materials, even though they were just as important to his business as his employees. However, we do hear demands that Able’s employees receive bonuses — even though Baker’s employees worked just as hard.

Before deciding who should share Able’s profits, let’s first decide if he should be forced to share them with anyone. This calls for a closer look at his profits and the role they play in a market economy.

Suppose Able’s sales exceed his costs of production by $30,000. That’s $30,000 of profits, right? Not necessarily. If Able has $100,000 of his own capital invested in the business, and the market rate of interest is 8 per cent, his business is costing him, in terms of lost interest, $8,000. If he is capable of making $20,000 a year working for someone else, his business is costing him, in terms of lost salary, $20,000. Able is making $30,000 by passing up the opportunity of making $28,000. His net profit is $2,000. And if government interventions should reduce his income to less than $28,000, he would be better off closing his business and firing his workers.

Of course, this analysis doesn’t take taxes into account. In normal times, approximately 50 per cent of corporate profits are seized by the government. In inflationary times, corporate profits taxes are likely to be even more confiscatory, for inflation exaggerates profits and turns many actual losses into apparent "profits."

How does this happen? Suppose Able buys an item for $8 and sells it a year later for $10. To most people — tax collectors included —that’s a clear $2 profit. But is it? Suppose that when Able tries to replace the item in inventory, inflation has pushed the price up to $10. Then Able is no better off than when he started.

In fact, he is worse off. The tax collector has seized half of his $2 "profit," so he has only $9 left to buy a $10 item. He is losing money and paying corporate profits taxes at the same time.

There is a second way that inflation creates phantom "profits." Suppose Able buys a machine for $100,000. The machine has an expected life of 10 years, so every year he writes off $10,000 on his tax return. Thus, after 10 years he has $100,000 set aside to buy a new machine. The only trouble is that in 10 years the price of the machine has risen to, say, $200,000. If Able can’t come up with an extra $100,000, his "profitable" business will have to close.

After all the ravages of inflation and taxation, Able may still have some profits left for himself. What will he do with them? If he wants his business to grow — if he wants more profits—he will reinvest them in the business.

Able will use his profits, and the capital his profits attract, to hire more workers. Perhaps he will take on some of the workers laid off by Baker. He also will purchase better — more efficient — tools of production. With these new workers and better tools his output of widgets will grow and grow.

There’s the rub. Able will produce more widgets and his profits will entice his competitors to produce more widgets. Labor, capital, and natural resources will flow away from the production of wad-gets and into the production of widgets. As the supply of widgets grows, the market price will tend to fall. Consumers will get more widgets at lower prices. They will all be better off. Able, however, will find the falling market price reducing his profits. If he is to stay in business, he will have to reduce his costs of production further. He will have to become even more efficient.

People say: "This is all hypothetical. I am interested in the real world."

Very well. There is nothing more real than the car in your garage. If the pioneers of the automobile industry had paid taxes at contemporary rates, those that still managed to make profits would have had much less money, compounded annually, to reinvest in their businesses. With a greatly diminished return on capital, they would have had a far more difficult time attracting outside investments through the sale of stocks and bonds. The automobile industry would still be in its juvenile stages, and you would probably know a lot more about horses.

This brief survey of issues surrounding profit and loss is, of course, by no means complete. Moreover, these are just a few of the many economic issues facing people throughout the world. However, I have tried to indicate how these issues can be resolved with understanding. For if understanding does not guide our actions, emotions surely will.