All Commentary
Saturday, December 1, 1973

Profit Sharing

So mysterious is the process of profitably producing and marketing anything — say, a pair of shoes — that many persons are willing to believe it is accomplished by exploiting the customers, or the hired laborers, or perhaps both. In that case, their reactions may run in all directions but tend to follow three main channels:

1.       Profits should be shared with employees.

2.       Consumers should organize as a cooperative in order to share the profits among themselves.

3.       The government can do it cheaper because it doesn’t have to make a profit.

Actually, these are not three separate alternatives to the free market — the profit and loss arrangement under open competition and voluntary exchange; they are but three different aspects of compulsory collectivism.

To demonstrate why that is so requires careful analysis and understanding of the profit and loss features of the market process. And we start with the fact that numerous individuals are competing for possession and use of scarce and valuable resources. There simply isn’t enough of any economic good or service to cover all the uses anyone might desire. So the problem is to use these resources as efficiently as possible, avoiding waste, and letting the willing customers judge what is efficiency and what is waste.

If the customer is to be the judge, this means that no seller can know precisely in advance what a given item may bring in the market. If he is a grower of potatoes, for instance, he knows there will be the costs of owning or renting a plot of land, a supply of seed potatoes, of fertilizer, of tools and labor for planting and cultivating and harvesting and preparing the potatoes for market. But he doesn’t know precisely in advance the amount of each of these costs. He doesn’t know what the weather will be; or how much of what quality crop the harvest may yield; or what customers will be willing to pay, for his potatoes in particular or for potatoes generally, at any given time during the marketing season. In other words, he is an entrepreneur, bidding for scarce and valuable resources for conversion to a product which he hopes customers will want at a price high enough to cover all costs, including his own labor and other investment, and still leave him a profit. If not, his is the loss.

In other words, profit is the reward willing customers accord an entrepreneur who efficiently uses scarce resources to satisfy their wants. And the amount of the profit, or loss, is never known until after the fact — after all the results of the production and marketing operation are complete, having been carried out in open competition with the producers and consumers of all other goods and services.

A moment’s reflection must reveal how nebulous and uncertain a thing is entrepreneurial profit as thus identified. It reflects a man’s superior skill at seeing and exploiting new or better opportunities to utilize resources to serve consumers — seeing a need and doing a job faster and better than others! For the moment competitors discover the opportunity and exploit it to any great extent, then the margin for profit will largely have disappeared. Then, perhaps one or a few of the most efficient competitors may still earn a profit; but most will only recover costs; and more and more will be driven by competition into the loss column or toward other lines of production. Thus is the opportunity for profit closed almost as rapidly as it appears in a competitive market situation; and in general it seems safe to say that more productive business activity merely breaks even (covers costs) or results in loss than yields an entrepreneurial profit.

What Kind of Profit?

Let it be clearly understood that we are not discussing here the terms profit or loss as customarily used in business accounting and measured by “the bottom line.”  What the XYZ Company reports as “profit”  or “income after taxes”  might possibly be made up in part of true entrepreneurial profit; but it most certainly consists in large measure of interest, for out of that “income after taxes”  must come any return on a stockholder’s investment. If he doesn’t recover the going rate of interest — either in dividends or in added value of his share — his investment has yielded a loss in the sense that he might better have invested elsewhere.

So, when the idea of “profit sharing” is proposed, the thoughtful proponent surely can not be thinking of sharing the interest portion of returns to investors. If they can’t earn interest, they’ll abandon that investment and seek another repository for their savings — with the result that the employee’s job disappears to the extent that he takes a share of the return that should have gone to the investors who provided the savings (the tools) upon which the job depends. Nor is this a consequence of some arbitrary decision rendered by a greedy capitalist — his determination to grind poor workers to the bone. On the contrary, the decision is rendered by consumers and their purchases — or their refusal to buy.

When all the facts are in, the consumers will have made known to the entrepreneur what profit, if any, his efforts have yielded. He will have been free to ignore the market, of course. He could have borrowed funds at twice the market rate of interest if he wanted to. Likewise, he could have paid two or three times the market wage rate to workmen. But it seems inconceivable that he could behave so magnanimously for very long without seriously depleting his personal savings and setting the stage for competitors to drive him out of business. “Good guys” aren’t all that popular; consumers pay willingly for efficiency, but have to be coerced into paying for anything else.

Incentive Pay

The proposal to share profits with employees is often justified on grounds of the extra productivity men generate as a result of “incentive pay.”  That is a cogent argument; payment of workers on a piece-work basis was being practiced successfully long before “profit sharing” came into vogue. Indeed, this is the principle under which the “cottage industries”  operated at the beginning of the industrial revolution, various jobs being “farmed out”  for completion in the worker’s home at so much per unit of product. In a sense, the worker in that case is his own entrepreneur; the more he produces, the more he earns. However, as production methods become more sophisticated, with more complicated and more expensive machines and assembly-line operations, cottage industries give way to the factory system and a tendency to pay workers by the hour rather than by the piece. Labor unions have encouraged the trend away from payment on a piece-work basis or incentive payments in general, despite protestations that union demands can and should be met out of company profits.

As previously suggested, where several companies have entered into competition in a given industry, producing the same or similar products, the likelihood is that only Company A — or a comparative few of those companies — will show any entrepreneurial profits that conceivably could be shared with workers or customers or investors. The greater number of competitors will barely yield the going market rate of return on investment, or even show a loss. (Bear in mind that one can never be certain just what portion of a company’s “income after taxes”  is strictly entrepreneurial profit and what portion is a necessary return to investors to induce them to leave their capital in that business.)

But if Company A is in a position to offer its workers a profit-sharing plan, then immediately the other competing companies would have to grant comparable wage increases or stand to lose employees to Company A. Obviously, some of the other companies would be driven out of business. The question then arises: Is Company A in a position to take on an uncertain number of additional employees and still offer its profit-sharing plan? If not, what becomes of those unemployed workers, except that they must tend to drive wage rates downward as they seek other jobs?

What Should Be the Price?

So, let us return to the basic premise of the market process: that numerous individuals are competing for possession and use of valuable resources. And the object is to determine how scarce and how valuable! What should be the price that most accurately reflects the supply-demand situation, leaving the ultimate choice to the consumer? In other words, we’re discussing the role of business in a system of voluntary exchange, as distinguished from government regulation and control — compulsory collectivism.

Without market pricing, there is no reliable system of economic calculation or business accounting, no way for competitors to know how well each is doing. For instance, reconsider the potato grower. How is he to know whether to use more land, or more seed and fertilizer and tender loving care per acre, to produce potatoes most economically? He looks to the market prices of these various productive resources to help him to a decision — and perhaps prays for rain and a good crop.

Or, suppose a person is seeking a job. He will be interested in knowing what other workers are earning in that job or in similar lines of work. And, of course, prospective employers are continuously checking to see what wage rates are being paid by other employers for comparable jobs. Neither the prospective employee nor the prospective employer really wants to wait until the end of the year —or the end of a season when profits might be known — to find out what wage rate should have been paid. Each prefers to know what the market rate is as of now, a figure that enables him to say yes or no, to do business or not.

Will the job pay $3.00 an hour, or is it to be $2.50 now and a chance for a share of profits later — if the project shows a profit? What wages are other employers paying? How many other workers are on a cash wage, and how many are willing to wait for a share of profits? What is the market situation? What is the going price for labor? The fact is that the profit-sharing system affords no way to know the market price, no method of economic calculation or business accounting, no reasonable basis for reaching a business decision.

And this is true, not only of profit sharing with employees, but also of the consumer cooperative idea of profit sharing. Either way, were the practice made universal, the market would be unable to provide a firm price structure that could be used for business accounting and upon which business decisions could be based. From that predicament, it would be a very short step for some to press the conclusion that the government should make that decision — manage the business —whether or not it could show a profit. The problem is that there is no way to show a profit, or to know the cost, or to find any other basis for a business judgment, if the market is not allowed to perform its vital function of price determination.

Sharing with Government

Until now, we have been discussing the profit-sharing idea as proposed or applied within the so-called private sector — sharing with employees, or consumers, or investors. But as intimated earlier, these are merely phases of or steps toward government management and control of business — compulsory collectivism. Another way to look at it is from the viewpoint of “profit sharing” with government — and this is the real problem.

The trend is well established. Businesses must pay income taxes graduated to fall most heavily on any company that appears to be operating profitably. “Excess profits” are subject to special taxation. And graduated personal income taxes are designed to sop up any profit that otherwise might have leaked out of the business into the pocket of some individual. Meanwhile, various governmental relief and welfare programs operate to reward those individuals and business ventures that the market had designated as losers or failures because of their inefficient and wasteful performance.

Beyond all those tax and welfare interventions with business activities and market pricing is the most serious political disruption of all: government designation of what traders may use as “legal tender,” the manipulation and control of money and credit—in a word, inflation. This is the ultimate in “profit sharing,” the process by which governments claim title to scarce and valuable resources in defiance of all attempts by the market to channel the ownership and control of scarce resources into the hands of the most efficient users, the successful innovators and entrepreneurs, the ones who best serve the choices and desires of consumers. By its control of money and credit and its inflationary policies, the Federal government effectively closes the market and defeats the market function of price determination. Inflation disrupts the means of business accounting and economic calculation to the point that conscientious entrepreneurs are led into serious malinvestment and waste of scarce resources. When entrepreneurs are thus conditioned to rely upon government intervention for their opportunities to earn a profit, the market economy is foreclosed and the people doomed to serfdom under socialism.

What hope is there to avoid this course toward certain disaster? It depends on the willingness of individuals to understand that traders know best what they want to use as money, that “legal tender”  laws hamper the market determination of prices, and that any form of profit sharing which rewards failure rather than successful business practice is license rather than liberty. Unless consumers are permitted to decide how much entrepreneurial profit goes to whom, there can be no free and prosperous commonwealth. 

  • Paul L. Poirot was a long-time member of the staff of the Foundation for Economic Education and editor of its journal, The Freeman, from 1956 to 1987.