Profit and loss
What is profit, really? is one of those hardy economic perennials. But any explanation of profit has to also be an explanation of loss since they are just the positive and negative forms of the same thing. Any analysis of profit that is not also an analysis of loss is analytically pointless - a simple test of whether an analysis of profit is worth bothering with is to consider whether it also works as an analysis of loss. (As Marx’s theory of surplus value does not, for example. But that rests on a rather bizarre “subsistence” view of production, where only labour is a truly legitimate contribution to production-since it [thereby] determin[ing]es its exchange value-so only the satisfying of labour makes production fully legitimate.)
The first thing profit is not is the return to capital. That an explanation of profit also has to be an explanation of loss implies that straight away. But even just considering profit, any production typically needs land (including natural resources), capital (the produced means of production) and labour. All these things have scarcity value, which means alternative uses, which means there is a price (explicit or implicit) for using them. The return to capital has no special standing.
Nor is profit a return to risk. There is a risk component in interest, for example, as there is in all prices for factors of production. All provision of land, labour or capital involves some risk (that you might not get paid, that you or it might get damaged, that you might incur unexpected liabilities, and so on). This risk component can be increased or decreased by specific or general circumstances. For example, good institutional structures lower risk. (Long-term interest rates are, therefore, quite a good measure of institutional risk.) But if there is a risk component in all returns to factors of production, profit is not return to risk.
The simplest way to understand profit is as the residual claim on the income of a business or particular sale. That is, profit (or loss) is the difference between what is paid out and what is received after all other claimants have been paid. A positive residual income is a profit, a negative residual income is a loss.
Which means that profit is not “just one thing”, for the level of residual income in particular sales, or in a business over time, can have many sources. Luck, to start with. Position, privilege, judgment: all these things can generate positive (or negative) residual income. Assuming a business does not have some specific privilege, nor some position-benefit unconnected to privilege or judgment, the residual income is the playing out of judgment and luck in particular circumstances. (Managing such uncertainty is, of course, central to operating a business.)
The notion that there is something inherently wicked in making a profit has a long history but that does not make it any more worthy of respect. A society whose firms (however understood) did not produce more value than they consumed would not last long. The bigger question is how to build into your economy an inherent tendency to produce more value than is consumed.
No better answer has been found that to allow individuals to build and invest in businesses seeking profit, suffering both the benefits of profit and the penalties of loss. As Milton Friedman said, the essence of a free-market system, which tends to be called a profit-and-loss system, is that the loss component is more important than the profit component. You need the discipline of the loss in order to keep the system going. A clear problem with all government provision is that it has such attenuated rewards for profit and attenuated penalties for loss.
The above superiority holds even including environmental externalities, since actually existing socialism has had a much worse environmental record than liberal capitalism due to the regulator is also the main (or even sole) producer, because of poor feedback mechanisms and hostile theory. In a situation where the regulator is not a producer, feedbacks are much better (both economic and political feedbacks) and valuing the environment, including environmental amenity (developed countries started improving their environment well before there was much of an environmental movement) is a legitimate part of the political debate then-depending on the regulatory structure-profit-and-loss can retard, avoid, ameliorate or restore, environmental damage.
Profit-and-loss is a tool, but an enormously productive and useful one, even if it is not “just one thing”.
The first thing profit is not is the return to capital. That an explanation of profit also has to be an explanation of loss implies that straight away. But even just considering profit, any production typically needs land (including natural resources), capital (the produced means of production) and labour. All these things have scarcity value, which means alternative uses, which means there is a price (explicit or implicit) for using them. The return to capital has no special standing.
Nor is profit a return to risk. There is a risk component in interest, for example, as there is in all prices for factors of production. All provision of land, labour or capital involves some risk (that you might not get paid, that you or it might get damaged, that you might incur unexpected liabilities, and so on). This risk component can be increased or decreased by specific or general circumstances. For example, good institutional structures lower risk. (Long-term interest rates are, therefore, quite a good measure of institutional risk.) But if there is a risk component in all returns to factors of production, profit is not return to risk.
The simplest way to understand profit is as the residual claim on the income of a business or particular sale. That is, profit (or loss) is the difference between what is paid out and what is received after all other claimants have been paid. A positive residual income is a profit, a negative residual income is a loss.
Which means that profit is not “just one thing”, for the level of residual income in particular sales, or in a business over time, can have many sources. Luck, to start with. Position, privilege, judgment: all these things can generate positive (or negative) residual income. Assuming a business does not have some specific privilege, nor some position-benefit unconnected to privilege or judgment, the residual income is the playing out of judgment and luck in particular circumstances. (Managing such uncertainty is, of course, central to operating a business.)
The notion that there is something inherently wicked in making a profit has a long history but that does not make it any more worthy of respect. A society whose firms (however understood) did not produce more value than they consumed would not last long. The bigger question is how to build into your economy an inherent tendency to produce more value than is consumed.
No better answer has been found that to allow individuals to build and invest in businesses seeking profit, suffering both the benefits of profit and the penalties of loss. As Milton Friedman said, the essence of a free-market system, which tends to be called a profit-and-loss system, is that the loss component is more important than the profit component. You need the discipline of the loss in order to keep the system going. A clear problem with all government provision is that it has such attenuated rewards for profit and attenuated penalties for loss.
The above superiority holds even including environmental externalities, since actually existing socialism has had a much worse environmental record than liberal capitalism due to the regulator is also the main (or even sole) producer, because of poor feedback mechanisms and hostile theory. In a situation where the regulator is not a producer, feedbacks are much better (both economic and political feedbacks) and valuing the environment, including environmental amenity (developed countries started improving their environment well before there was much of an environmental movement) is a legitimate part of the political debate then-depending on the regulatory structure-profit-and-loss can retard, avoid, ameliorate or restore, environmental damage.
Profit-and-loss is a tool, but an enormously productive and useful one, even if it is not “just one thing”.