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Source link: http://archive.mises.org/14678/what-drives-profits/

What Drives Profits?

November 18, 2010 by

It is the seeking of profits that is the key to increased living standards for everyone. But high profits do not necessarily correspond to real economic growth and can come about due to adverse circumstances. FULL ARTICLE by Kel Kelly

{ 23 comments }

Ryan November 18, 2010 at 10:47 am

Contrary to the Smithian/Marxian view, wages are deducted from profit, not vice versa.

I think the majority of people today are still under that false, Marxian impression. Hardly a day goes by that I don’t see comments on a blog professing that view.

Jonathan M. F. Catalán November 18, 2010 at 11:05 am

A note of interest, higher capital investment does not require a fall in profit (economy-wide). You can have the same level of nominal spending on investment, or less (to a degree), and invest a greater amount of capital. This is because increases in productivity will also bring about decreases in the prices of relevant goods, allowing a greater amount of goods to be purchased with the same nominal expenditure.

Kel Kelly November 18, 2010 at 2:19 pm

Good point, Jonathan. But I think we have to distinguish between a greater nominal amount of capital investment and a greater proportion of investment spending as a percentage of all spending (productive spending versus consumption spending).

Economic growth can definitely increase solely by having the current capital goods create more capital goods, without increasing the proportion of spending devoted to capital goods and labor versus consumption spending. This does not alter the rate of profit.

But a greater proportion of spending allocated towards productive spending (capital goods and labor) and away from consumption spending will result in a lower rate of profit for reasons explained in the article.

Troy Doering November 18, 2010 at 12:40 pm

It Should really be were do the profits go. The correct answer is capital to grow your business. A shareholder should really be focused on long term value of the stock. over 30 – 40 years and not the short term Quarterly dividend. whether your the Janitor or CEO, Long term should also be your goal, job security. raises and bonus reflecting real time health and wealth of the business, Economy, inflation. not locked in numbers from two or three years ago when a contract was negotiated. A little common sense like this and everybody wins, instead of a pack of greedy savages fighting over the scraps of a failing economy.

greg November 18, 2010 at 12:54 pm

It appears to me that your concept of profit comes from investing in the futures market where you have a pool of money where players place bets and the total profits equal the total losses. If money is taken out of the pool, profits would be reduced.

This concept cannot be applied to the economy as a whole because of the gain in value associated with captital expendure beyond the cost of those expendures. Then there is the increase in profits without additional expendures. Basically the economy is much more dynamic than the futures markets.

Furthermore, profits companies report today should not be used as the main source to judge a company’s performance because many times these numbers are manufactured by management as they keep sending the audit team back to the backroom to get the number they want. That is why companies can take a hit on their stock price when they beat on the bottom line and fail to meet expectations in other areas like gross margins and total revenue.

I don’t even want to get started on GAAP and non-GAAP profits, mark to market, goodwill expenses and a whole host of accounting tools to effect profit levels. And with all that going on, the value we assign any company is based on projected profits 6 months out.

Kel Kelly November 18, 2010 at 2:16 pm

Greg, I’m referring to the real economy. The article explains the components of business spending and business revenues which allow them to theoretically be equal.

Beefcake the Mighty November 18, 2010 at 2:34 pm

Do you believe money is part of the real economy?

Kel Kelly November 18, 2010 at 4:43 pm

yes

Beefcake the Mighty November 18, 2010 at 10:11 pm

Really? Because, it’s hard to reconcile this answer with statements from your article like this:

“In this broader view of profits, time preference and the corresponding savings rate affect the rate of profit by affecting the rate at which people disinvest and consume their capital.[3] The higher people’s time preference, the faster they will consume their invested funds and the higher will be the rate of profit.

This line of reasoning is aligned with the traditional view of time preference and savings: the fewer savings available, the higher the rate of interest. (It must be remembered that interest exists only because profit exists.)

The explanation above describes what constitutes real profits — profits in the economy prior to the effects of money and credit.”

Of course, the third paragraph directly contradicts your answer above. You seem to view “real” profit as existing apart from the “effects” of money. Let us note that according to von Mises’ socialist calculation argument, allocation of capital goods is impossible outside of a market for such goods. If this is true (and I believe it to be so), money plays a rather central role here, it’s not secondary as you seem to suggest.

The second paragraph is puzzling too. You correctly identify earlier in your article the role error (or disequilibrium, if you like) plays in the formation of profit/loss. The conventional Austrian view (which has problems, it should be admitted) associates interest with the “discount” future goods receive relative to present goods. This has nothing to do with entrepreneurial error (ie, profit/loss).

Re. the first paragraph, as just noted, time preference concerns the relation between current and future *consumption*. However, profit (and a fortiori, profit rates) can only be reckoned in terms of *money* (as this is the only good in the economy that permits such calculations). Your association of changes in time preference with changes in profit rates assumes that the latter is a proxy for the former. Maybe it is in some sense, although I am somewhat skeptical. Regardless, it conflicts with your claim that you consider money to be part of the real economy.

Kel Kelly November 19, 2010 at 11:06 am

Beefcake, I’m not sure I understand your beef. I don’t see any contradiction. Time preferences, physical desires, entrepreneurial actions—non monetary things—can indeed affect how we spend money; they affect the monetary economy. If people choose to save more, they save money. If, instead, they have a high time preference, they will consume. If their money is directed at consumption, the rate of profit—as measured in money—will be higher. If they save, their money is directed towards capital goods production, and the rate of profit will be lower. The non-monetary economy is related to money. This is why, for example, money printed by the central bank physically distorts the production structure.

I first show how income statement profits derive in an economy where the quantity of money is static, and then I show the effects of printing money on the income statement rate of profit.

I did state early on that I am discussing profits in a wider sense. Specifically, I’m discussing how income statement profits (which are in money terms) come about. Those monetary profits change based on 1) people’s time preferences and the way their choice of consumption versus production, and 2) credit expansion.

Actually, I see where I might have confused you. You referred to this statement:

The explanation above describes what constitutes real profits — profits in the economy prior to the effects of money and credit.”

Perhaps I should have stated that it is what constitutes profits prior the effects of NEW money and credit BEING CREATED ARTIFICIALLY. I didn’t mean to state that I was first explaining “non-monetary” profits.

Does that clear it up?

Beefcake the Mighty November 19, 2010 at 11:52 am

I’m afraid it doesn’t.

“Time preferences, physical desires, entrepreneurial actions—non monetary things—can indeed affect how we spend money;”

Of course. They affect a great many actions.

” they affect the monetary economy. ”

Well, the “monetary economy” is precisely the institution by which factors of production are allocated to different endeavors, via (anticipated or expected) profit-and-loss calculations. Without such an institution, there can be NO such allocation. Speaking of the non-monetary economy and the monetary economy is a false dichotomy.

“If people choose to save more, they save money. If, instead, they have a high time preference, they will consume. If their money is directed at consumption, the rate of profit—as measured in money—will be higher. If they save, their money is directed towards capital goods production, and the rate of profit will be lower. ”

Here you are equating changes in time preference (the preference for present vs future goods) with changes in money expenditures. A change in time preference can manifest itself in a particular money expenditure, but it’s not the same thing.

“The non-monetary economy is related to money. This is why, for example, money printed by the central bank physically distorts the production structure.”

I’m not sure what you mean by “physical” here. Presumably you mean that central bank action results in factors of production being allocated into different endeavors than they otherwise would (although characteriziing such reallocation as a “distortion” is a question-begging feature of conventional ABCT). True, but ANY change in conditions (eg, a change in expenditures from ice cream to beer) results in a change of the structure of production. Again, though, this happens through profit-and-loss calculations. There is only ONE economy. And it is only in a money-using economy (as opposed to a barter economy) that it is possible for a structure of production to exist (the socialist calculation argument).

My “beef” with you is that like many Austrians, you implicitly assume that monetary calculations are proxies for value calculations. This is false. What you need to explicitly recognize is that money is a good in its own right, and that there is no such thing as a value calculus (not because cardinality is false [no economist believes in cardinal utility], but because the concept of value equivalencies [marginal rates of substitution] is false). Money is a medium of exchange, and therefore has a purchasing power. In analyzing capitalist economies, you need to consider how (1) factors of production are allocated via monetary profit-and-loss calculation, and (2) how changes in the purchasing power of money (not simply changes in its supply) impact these calculations, thus affecting the structure of production. This is where the unique Austrian contribution is.

Kel Kelly November 19, 2010 at 1:20 pm

[Strangely, there was no "reply" button underneath your posting, so I'm doing it here.]

Beefcake,

I’m just not seeing how anything I’ve said is really at odds with your (1) and (2) at the bottom of your statement. I have to admit, I don’t have tons of time to read your comments over and over until I see clarity. If this is a big issue for you, and you would like to resolve it, could you just try to sum up the flaw in my arguments, or show how I’m contradicting myself in a sentence or two in plain English?

Perhaps this is the crux of it?:

“Here you are equating changes in time preference (the preference for present vs future goods) with changes in money expenditures. A change in time preference can manifest itself in a particular money expenditure, but it’s not the same thing.”

Of so, please explain. I’m not equating anything here. I’m stating what you stated in the second sentence.

Phinn November 18, 2010 at 5:41 pm

There is no such thing as profits. What is typically described as profit is merely the component of the enterprise’s revenues that is attributable to the investment and executive functions performed by the owners of the company. Those decision-making functions have a market price, just like everything else.

The unique aspect of this component of the enterprise’s revenue is that it is paid last, after all of the fixed, advance costs of production are paid (each according to its own market value). It therefore bears the most risk of not being paid, since it is only paid after the revenue derived from the market activity of the enterprise is actually realized (i.e., after sales are made). The other costs (e.g., wages) are typically paid in advance of the sale.

Jordan Viray November 18, 2010 at 8:50 pm

“There is no such thing as profits.”

Actually there is such a thing. Just because we can look at “profits” as the “price” of entrepreneurial ability does not somehow invalidate the term.

Phinn November 22, 2010 at 1:27 pm

That’s just a matter of terminology. My point is that what is called “profit” is merely the market price for the entrepreneurial component of delivering a good or service to a buyer. That entrepreneurial function has a price in the marketplace, just like everything else has a price. It can be thought of as a component of the total price of the good as a whole, along with what are commonly thought of as “costs” or “expenses” in that price (materials, labor, management of labor, marketing, distribution, packaging, research and development, etc.).

The only substantive difference between “costs” and “profit” is that the entrepreneurial component of revenue is a major factor in making the decisions that direct the future allocation of all of the other components. In other words, when the entrepreneurial-market-price falls (i.e., the profit margin), the entrepreneur’s reaction is to make changes in one or more of the other production factors in an effort to maximize the price for his part. That’s what he gets paid to do, after all.

But the buyer does not care about any of that. To him, there is one price, and the components of it are not known, knowable, or relevant. Buyers don’t care about the Labor Theory of Value any more than they care about the idea of a Just Profit Margin. The overall market price for any good is affected by the total costs of production, which includes the prices that the various components are willing to accept for their part in it, including labor, suppliers and entrepreneurs alike.

Jordan Viray November 23, 2010 at 8:30 pm

No, you stated that there was no such thing as profits. That’s nonsense as I pointed out.

Alex November 19, 2010 at 10:19 pm

There are a number of strange contentions in this paper. First of all, there is no explicit statement that the author defines the word “profits” differently from its traditional meaning, that is to say total revenue – total expenses (what the author calls total costs).

Then the author states that: “Costs in fact do equal revenues.” The author declares that costs equal business expenditures on labor, materials, and long term capital goods. But this is an error. Business expenses include only the depreciation of capital goods (those purchased in the current period as well as those purchased in prior periods) and not the purchase of capital goods in the present period.

A little later, the author states that: “When funds invested in companies are withdrawn and are instead consumed to purchase consumer goods or services, there results economy-wide spending over and above the spending that comes from the spending on capital and wage payments; this spending generates sales revenues without corresponding costs.” But this is absolutely false; all sales revenue generates costs (expenses).

Alex November 20, 2010 at 10:45 am

The main problem in this paper is that the author attempts to derive causal relationships for “profit” from an identity. Profit=Revenue-Expenses is an identity relationship defining profit. No causal inferences with regard to profit may be ascertained from this relationship. Neither does replacing Revenue and Expenses with their components help at all in this regard.

Kel Kelly November 20, 2010 at 4:59 pm

Hi Alex,

I think you’re not understanding what I stated, or not studying the explanation thoroughly. If I’m not writing clearly enough, I recommend this, which is surely a better explanation: http://mises.org/media/1503

Secondly, I don’t understand how you could contend that not all business expenditures represent costs. Everything a business spends on producing a product is it’s cost: salaries, paper clips, cost of goods sold, travel expenses, depreciation/capital goods, etc.

I am not defining profits any differently than Revenues-Costs=Profit. I am simply explaining the profit component.

I suggest you read the paper again carefully.

Beefcake the Mighty November 23, 2010 at 1:52 pm

Kel,

Thanks for drawing attention to the fascinating lecture by Reisman. He makes a brilliant point, namely that any explanation of profit and/or interest *must* take money into account; I’ve been trying to make this same point on various discussions here on the blog. His critiques of conventional (and related) time preference and productivity theories of interest are outstanding and should be listened to by all Austrians. Unfortunately, his alternative theory of interest is very weak, and frankly sounds like it’s driven by typical Randian deifications of the businessman, as he tries awkwardly to associate accounting conventions for depreciation with time preference and the structure of production (it’s clearly tied into this cost-of-production rubbish he’s been trying to resuscitate over the last few years). It’s very puzzling that he correctly emphasizes the importance of money yet narrowly focuses (as you do here) on the supply of money, and not the more relevant concept of the purchasing power of money (which depends both on supply of and demand for money).

I highly recommend the following articles by Huelsmann (HT to newson for emphasizing the second one to me), they should help clarify what the main issues are here:

http://www.guidohulsmann.com/pdf/Demand_Money_Time_Structure_Production.pdf http://www.guidohulsmann.com/pdf/Time_Preference_Investment_Expenditure.pdf

Alex November 20, 2010 at 5:53 pm

I’ll listen to the Reisman roundtable discussion and respond. I’ll also re-read your paper. Since this thread is getting old, I’ll respond to you directly by e-mail.

Kel Kelly November 20, 2010 at 6:11 pm

Cool.

Beefcake the Mighty November 23, 2010 at 9:50 pm

Here’s a good example of some neoclassicist cluenessness on this issue:

“For instance, Reisman tends to work in terms of money prices instead of relative prices, and money rates of return instead of goods rates of return. 11 Why?”

at

http://mises.org/journals/rae/pdf/RAE10_2_8.pdf

(Note that Tabarrok is by far the more principled and radical of the duo comprising marginalrevolution.com; Tyler Cowen is a tool of the highest order.) However, Reisman’s response at

http://mises.org/journals/qjae/pdf/qjae1_3_5.pdf

displays a good deal of cluelessness of its own, esp. p. 50 where he claims that demand only has meaning at the level of the economic system as a whole; note further his focus on the *quantity* of money (stressed also in his lecture) as the relevant driver.

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