Profits

Dear Friends,

Are profits the life blood of the economy, or do they reflect greed? My answer: Both of these.

Profits are the return on capital (interest and dividends), just as wages and salaries are the return on labor. Land, labor, and capital (the factors of production) all combine to produce what we consume. Real capital consists in the physical sources of production, such as factory buildings and machines. Machines enable workers to produce more than they could without them. Buildings keep both workers and machines dry, warm, and undamaged. The entire gross domestic product of any country can be divided into the amounts arising out of land (rent), labor (wages), and capital (profits). Can you think of any good whose value is not ultimately divided among these three? (I can't).

Greed applies to wages, rent [1], and profit. The worker may be greedy by demanding extremely high pay, such as a baseball star or a CEO. A farmer may be greedy by demanding price floors that force others, including the poor, to pay higher prices for sugar. (Most farm subsidies are paid to the rich, not the poor.) A capitalist (an owner of capital[2]) may be greedy by demanding a monopoly or by violating the environment to ensure higher profits.

Notes on Rent and Capital:

Economists call the returns to land "rent," but that is a technical term, different from the ordinary concept of rent.
Financial capital (stocks, bonds, etc.) evidences the ownership of real capital.

The greedy ones make the news with their transgressions, so we usually ignore the many, many people who do not demand more than their due. While greed is characteristic of all types of people, not just capitalists, many of "all types" are not greedy. Hence I believe greed is a characteristic of some individuals, not of a "system" or of organizations such as multinational corporations. We should not condemn MNCs for their greed. If anything, it is the people within them who are greedy.

If you think capitalists are greedy, please reflect on yourself. How much will you depend, in your retirement, on profits of corporations? What would you pay for education were it not for profits on university endowments? Would you pay more for insurance (fire, life, health, auto) if the insurance company did not earn profits on its investments? If you saved up for a house, then the services provided by that house (warmth, protection from the elements, etc.) are the profit from your investment. Are you greedy if you keep that profit to yourself, instead of opening your house to the homeless?

Our society values creatively and change. In the economic sphere this is part of competition, which tends to reduce costs. Our society rewards innovation with higher profits than those earned in the ordinary course of business. If you write a book, you get royalties, but only if your book sells well (my books sell reasonably, but nothing like Harry Potter). If you patent an invention, you receive a higher than normal return, but only if your invention sells well. (The inventor of skateboards must have made a killing). Our society generally thinks this is fair. But any bonanza is usually temporary; after some years the investment sinks back to a "reasonable" return.

We also think it is fair that those whose inventions do not pan out should earn no profits, indeed should lose their investments. Thus, risk is rewarded if it succeeds, and the risk-taker takes the lumps if it does not. Pharmaceutical companies make up for losses on experiments that don't pan out by charging higher prices for those that do. Whenever you buy a prescription, you are also paying for many unsuccessful attempts.

Externalities

Some companies make profits based on capital that is not their own. Pure air, for example, is the common property of many. A company that fouls the air without paying for it receives a stolen profit, stolen from the people who suffer. The same for water and other goods provided by nature. These are known as external costs; they are "external" in the sense that someone other than the producer pays them. Logging companies using federally-built roads take advantage of external costs. Environmentalists should lobby to internalize the externalities by requiring firms to pay costs of pollution. Loggers should pay for the logging roads. If everyone paid all costs (and passed them on in the price to the consumer), environmental degradation would sink to restorable levels.

Stockholders insist on profits

Stockholders press their management to make the greatest profits possible, because doing so increases the market values of their holdings. Is this moral? According to our system, Yes, because profits are earned through (1) inventions, (2) producing goods that people want, and (3) operating efficiently, to reduce costs and conserve resources. Especially in the latter respect, environmentalists should favor the pressure on corporations to earn high profits.

Look at it another way. Income reflects resources created, since goods that are sold are resources. Expenses reflect resources consumed, such as labor, depreciation of machinery used in production, and raw materials. The excess of income over expenses, which is profit, therefore reflects the excess of resources created over resources consumed. This balance should cheer environmentalists.

Of course, the wrong resources may be created, if we feel we should drive VW bugs rather than SUVs. But that is consumer choice. That problem lies with the people, not the system. Likewise, of course producers dump waste in public waters or belch exhaust into public air. So we pass laws (or file lawsuits) to prevent them from abusing externalities. Our system is one of checks and balances. If corporations violate the environment, it does no good to blame them for trying to maximize profits, for that is what they are supposed to do. There's no point in saying: "Please be good little boys, and don't do that." We must have laws with teeth, to hold them in line.

It is sometimes thought that high profits are taken at the expense of workers. Well, surprise: the firms that earn the highest profits are the very ones that pay the highest wages. In 1942, Joseph Schumpeter, one of the world's greatest economists (under whom I had the privilege of studying) observed that this had been happening at least since 1899. The Economist (5/30/98) noted that "numerous studies, looking as far back as the 1920s, show that industries where profits and average productivity are higher tend to pay all workers more."

Other researchers, including the International Labor Organization, have reported that multinational corporations, on average, pay higher wages and offer more social services (health care, pensions, education, housing, etc.) than their workers could earn with other employers. Through worker training, they bring needed skills to less developed countries, which could be obtained in no other way.

Nevertheless, the greed for profits leads many corporations to violate the environment and to demand monopolies, protection from foreign competition, and subsidies. It leads some to insist on laws (such as taxes) in their favor, and a few to try to overthrow "hostile" governments. These practices must, over time, be outlawed either legally or culturally. If culturally, corporations will not engage in them because "it isn't right" or because their neighbors do not. Slavery, whipping workers, child labor, and unsafe conditions have all been abolished, both culturally and legally, in the more developed countries but not in all the less developed. Since "the system" that includes profits is far from perfect, we must continue to correct it. Since it is the life blood of our economy, we must also preserve it.

If instead, you would propose dismantling "the system" because it promotes profits (and greed), please tell me what system you would suggest instead. Surely not one that concentrates power more than it is concentrated under our present system? If you propose to correct the system for its faults, you are on my team. Is greed inculcated by the system, or is it learned in families, church, schools, and schools? I think both, but change will come mainly from families, churches, and schools, and only later from passing laws.

To keep this letter to a reasonable size, I have not taken up (1) capital gains, (2) socially desirable investment, (3) non-profits, and (4) short-term versus long-term profits. I have also summarized a very complex issue, which deserves more extended treatment: external costs, especially environmental costs. Possibly others. These will be the topics of future letters.

Sincerely your friend,

Jack Powelson

Readers' Comments:

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Not all markets are equal in terms of making information available, allowing different actors comparable choices, etc. Just as there are circumstances where workers can use pressure to negotiate higher wages unfairly (and so diminish profits), sometimes managers can use pressure to unfairly negotiate higher profits, and so diminish wages. A strong market, with transparency, other options for actors, etc, limits this as much as any human institution can, but a weak market may not be able to.

— Geoffrey Williams, Bethesda (MD) Friends Meeting.

Unfortunately the greedy and the media coverage have created a crisis for legitimate profit makers. I am trying to get Bellarmine University, where I am Executive in Residence, to call a conference of the top local business executives to address the question: "What can we as local business executives do to help restore confidence in the system?"

— Lee B. Thomas, Jr., Louisville (KY) Friends Meeting, Business Executive.

I thought TQE #44, on profits, was spot-on: but I wish you had spent a little time on the technical difference between normal and monopoly profits. I think it would be useful if those whose tendency is to excoriate all profits could understand the functional distinction between those profits which arise from the normal operation of the system (and are necessary to make it work right) and those which arise from distortions of the system (and tend to interfere with its operation). Your piece pointed out that some profits are indeed excessive, but it might have been good to remind your readers that the differences are economically as well as morally significant, and that it is at least theoretically possible to tell which is which.

— Bill Ashworth, South Mountain Meeting, Ashland (OR).

Suppose a company never paid dividends, how much would you pay for its stock? You might buy the stock on the assumption that there was a bigger fool, who would pay even more for the company once its profits had grown (even though these would never be paid out), but surely we would not want to say that the allocation of capital in the US is basically built on the bigger fool theory? Yes I know about the double taxation of dividends, but if the logical end-point is that dividends should never be paid, where does that leave the allocation of capital?

— Will Candler, Annapolis (MD) Friends Meeting.

You hit the nail on the head with double taxation of dividends. Some companies, such as Microsoft, do not pay dividends, preferring instead to retain earnings for future investment. In that case, the value of the company increases, so the value of the stock grows, and stockholders who sell their holdings earn capital gains instead of dividends. — Jack

I'd like to express my curiosity about whether classical liberalism accommodates worker ownership of enterprises. I'd also like to know if you think that environmental and social costs can truly be comprehensively internalised in the prices of goods and services (by road-pricing, land and resource privatisation, liability assignments, etc.).

— Paul Connor.

Modern technology has made some of this possible, through, for example, electronic devices to count cars as they speed along, but not for everything. — Jack

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PUBLISHER AND EDITORIAL BOARD

Publisher: Russ Nelson, St. Lawrence Valley (NY) Friends Meeting

Editorial Board

Roger Conant, Mount Toby Meeting, Northampton, MA.
Caroline Conzelman, Boulder (CO).
Ann Dixon, Boulder (CO) Meeting of Friends.
Virginia Flagg, San Diego (CA) Friends Meeting.
Merlyn Holmes, Boulder, Colorado.
Janet Minshall, Anneewakee Creek Friends Worship Group, Douglasvillle (GA).
Jack Powelson, Boulder (CO) Meeting of Friends, Principal Editor.
J.D. von Pischke, a Friend from Reston, VA.
Geoffrey Williams, Attender at New York Fifteenth Street Meeting.

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This newsletter was formerly known as The Classic Liberal Quaker.