1. Skip to navigation
  2. Skip to content
  3. Skip to sidebar
Source link: http://archive.mises.org/15317/where-profit-comes-from/

Where Profit Comes From

January 13, 2011 by

The theory of profit/interest has major implications for the understanding of capital accumulation, the determination of real wages and the general standard of living, taxation, inflation/deflation, and the business cycle. FULL ARTICLE by George Reisman

{ 31 comments }

greg January 13, 2011 at 10:26 am

Higher wages does not reduce capital investment, it actually increases it. Basically, as wages rise, the only way to get the unit cost down is to increase productivity and that requires capital investments. One of the many reasons manufacturing is returning to the US from China is this increase in productivity in the US. I know of one company that supplies measurement control equipment and they have seen a huge shift from Asia to the US over the last couple years.

Profits is not about what you pay, it is about the return on what you pay. In my business I look at value for the money I spend, many times the cheapest option delivers the smallest return.

Captain_Freedom January 13, 2011 at 12:40 pm

greg,

>Higher wages does not reduce capital investment, it actually increases it. Basically, as wages rise, the only way to get the unit cost down is to increase productivity and that requires capital investments.

This is incorrect. You are assuming that business firms have unlimited funds with which to make investments. That is not the case. Ever. Money is, like all economic goods, SCARCE. If business firms increase their expenditures OF MONEY on factor of production W (wages), then this increase MUST come at the expense of a decrease in expenditures OF MONEY in either Net Consumption (business owner’s own consumption through reduction in dividends and other funds drawn directly from business firms), or Gross Investment (business owners purchase of capital goods), or a combination of both.

The increase in productivity that comes along side a fall in unit costs of capital goods and thus increase in quantity of capital goods demanded and thus increase in capital invested per average worker, is NOT the same thing as an increase in the quantity of capital goods demanded that results from an increase in the MONEY demand for capital goods. In other words, you just committed the most common economic error regarding supply and demand, that is, confusing an increase in the quantity of a good demanded that results from a fall in price, with an increase in monetary demand.

A business that pays higher wages will indeed tend to seek to reduce its other business costs, but this cannot be achieved the way you say it can, which is for the business to wish money into existence, make a higher expenditure for capital goods, and then take advantage of lower unit costs of production on the basis of a lower cost of goods sold. You are ignoring the fact that higher wages means that business firms have LESS money to make expenditures on capital goods and/or finance their own consumption.

Finally, to close off any last vestiges in your mind that would give you the impression that higher aggregate wages will lead to higher capital investment, please understand that the amount of money going to finance businessmen’s own consumption tends not to be as great as unions would have everyone believe. This consumption is financed out of profits. After taxes and after reinvestment of a portion of past profits, the percentage of total INCOME in the economic system that represents consumption income on the part of business owners is not much more than 10-20%. This of course means that any rise in wages that comes at the expense of this money is relatively small, compared to wage payments in general, which usually hover around 70% of all incomes in the economy. To see a portion of the 10-20% “spread” over the entirety of the rest of the 70%, will not make the average wage earner any better off in the long term, assuming of course that the majority of additional wages will be spent on the wage earner’s own consumption. Add to this the fact that business owners tend to consume more or less according to the height of their capital, not their income, and we can see that higher wages will overwhelmingly result in LESS capital investment, not more.

greg January 13, 2011 at 1:38 pm

Not all productivity advances require capital goods and the smart businessman recognizes that. The way you run your business and manage your employees can lead to increased profits. From those increased profits the business owner can increase capital investments. This is not theory, this is how it works. One of my business associates is a CFO of a fair sized bakery. Faced with this recession and higher labor cost, they redesigned their production lines, invested in capital equipment and the bottom line is they decreased the number of workers, decreased the number of lines and increased output. Even faced with increased commodity cost today, his cost structure allows him to keep his finished goods price stable while maintaining profit margins. The main point you are missing is that labor cost is a small percentage of the total cost of most manufactured goods.

With the economy recovering, employers are looking to pay their employees more because they recognize that they have pushed them close to their limits and know if the employee leaves as employment levels increase, they stand to loose that productivity advantage.

And finally, to close off any last vestiges in your mind that would give you the impression that higher aggregate wages will lead to higher capital investment, the fact is wages have increased over the last 100 years while productivity has increased more than 1000 times. This tells me that while capital is scarce, it still finds its way into the market place in a big way.

The funny thing about life is that I learned more about profits from a man that performed construction cleanup around my job sites than any college professor I had. He managed his business for 40 years, put 3 kids through college debt free, held 2 patents and managed to have a good retirement.

Captain_Freedom January 13, 2011 at 4:12 pm

>Not all productivity advances require capital goods and the smart businessman recognizes that.

Nobody claimed otherwise. What is true is that the overwhelming part of productivity advancement in our economy is in fact based on capital accumulation. An individual worker can increase their personal productivity only up to a certain point, after which it would be physically impossible to produce more output because there simply isn’t enough physical materials/equipment (capital) as input. Yes, the productivity of a worker who uses a basic hand shovel can have their productivity increased through education, technique, effort, etc. But if that worker’s employer gives them a steam shovel to work with, which represents an increase in capital invested per worker, then the worker will be able to produce much more.

The law of diminishing returns will fully set in at some point if capital investment is held constant, at which point productivity cannot increase any further. But, capital accumulation and technological advancement can overcome diminishing returns to enable worker productivity to keep increasing.

The few cases of increased productivity on the basis of things other than an increased investment of capital goods per worker is minor and inconsequential once one engages in a long term outlook on the economy.

>The way you run your business and manage your employees can lead to increased profits. From those increased profits the business owner can increase capital investments.

You are talking about cost management. Obviously more capital investment can lower cost of goods sold, which means you are not actually providing a true “alternative” to capital investment as a source for increasing profits.

>This is not theory, this is how it works. One of my business associates is a CFO of a fair sized bakery. Faced with this recession and higher labor cost

Why would their labor costs be HIGHER during a recession? Most businessmen I know were compelled to LOWER labor costs, and in virtually all cases, the workers took the pay cut rather than quit or be fired.

>they redesigned their production lines, invested in capital equipment and the bottom line is they decreased the number of workers, decreased the number of lines and increased output.

Your example is consistent with my argument, and inconsistent with yours. You are saying here that your business associate invested in more capital as a means to lower costs and increase productivity. What’s the issue here again?

>Even faced with increased commodity cost today, his cost structure allows him to keep his finished goods price stable while maintaining profit margins. The main point you are missing is that labor cost is a small percentage of the total cost of most manufactured goods.

On the contrary, it is you that is missing the main point. The main point is not how large labor costs are relative to other business costs. The main point Reisman is making is why higher wage payments do not translate into the effects claimed by Keynesians.

Now that you brought it up, wage costs are in fact a substantial portion of total business costs. It varies from industry to industry of course, but generally wage costs make up a very large portion of total business costs. On average, it hovers around 40% of total business costs. In no case is it a “small percentage”.

>With the economy recovering, employers are looking to pay their employees more because they recognize that they have pushed them close to their limits and know if the employee leaves as employment levels increase, they stand to loose that productivity advantage.

Notwithstanding the fact that we can quibble over whether the economy is recovering or not (I hold that it isn’t, it only APPEARS to be recovering, much like it APPEARED that we were wealthy during the real estate boom), it only makes sense for an individual businessman to pay higher wages if that is what the labor market is generating. Yes, if an employee will leave unless they are paid more, then it may be the case that the employer should pay them more. The main point however is that Keynesians are not thinking in these terms. They aren’t content with accepting what the market will bear. They want to go beyond market forces and increase wage payments politically, which is destructive.

>The funny thing about life is that I learned more about profits from a man that performed construction cleanup around my job sites than any college professor I had. He managed his business for 40 years, put 3 kids through college debt free, held 2 patents and managed to have a good retirement.

That isn’t funny if you understand that my position, Reisman’s position, indeed all Austrian’s position, is that entrepreneurship cannot be taught. Entrepreneurs understand their own market better than any college professor, however this does not mean that entrepreneurs know more about economics than college professors. Here, professors can contribute by showing the contribution entrepreneurs make, and, in some cases, help them overcome many economic fallacies and biases that pervade our entire society. After all, the fact that one *is* a businessman does not mean that they *are* a good one. The market process weeds out bad businessmen and rewards good ones. As such, a single example of a 40 year veteran of business who put his children through school debt free does not prove anything about economic theory proper. It is a historical example. I could have just as easily given you a historical example of a businessman that completely failed, and not have said anything more enlightening.

Beefcake the Mighty January 13, 2011 at 4:44 pm

Great, another businessman who cannot distinguish his own business from the economy as a whole.

John James January 13, 2011 at 5:56 pm

Hayek himself addressed this exact flawed argument here in this interview.

Phinn January 13, 2011 at 11:52 am

Perhaps the simplest way to conceive matters is by starting with the fact that profit is the difference between sales revenues and costs.

Profit is the market price for entrepreneurship.

Marx famously (and erroneously) believed in the Labor Theory of Value, one of the implications of which is that the capitalist skims the “excess value” from the worker’s productivity. The value of the worker’s output, the socialist argues, is equal (or close to equal) to the market price of the thing he makes. The capitalist, they say, then skims off a part of this value for himself, giving the worker some fraction of it. Their simple-minded solution is to cut out the capitalist, and have the workers own the operation, so as to eliminate this skimming. But since that can’t be done, they create this thing called a “State,” which has no profit-motive, they say, to act in the stead of the capitalist, so that the skimming effect is reduced as much as possible. A few tens of millions of deaths later, we see how wrong all of this is.

The wages for a laborer (such as the prototypical factory worker, to borrow a Marxist icon) are not determined in the first instance by the price of the thing he makes, as Mises showed. Wages are set by the market price for such labor, which is determined in part by the market price of the thing produced, but also by the supply and demand in the labor market for laborers of that kind.

So, too, the market price of the thing that the firm makes is not determined by the wages of the laborer, but rather by the supply and demand of that thing in the marketplace. That price will fall to market-clearing levels, and if that means that the manufacturer takes a loss, then so be it (although such losses will also mean that the firm will soon go out of business, or it needs to find another line of production).

For a firm to be solvent (and more importantly, to REMAIN solvent) the costs of production as a whole must be less than the revenue they generate. This also means that every component of the production must contribute at least as much as it costs, otherwise, that component is being subsidized by the other more-productive components, and is a net loss to the firm.

Although it is not always easy or clear exactly how to apportion the fraction of revenue that each component helps to generate, firms do work to eliminate these unproductive, net-loss components. It can be done (and is done through the use of market prices). Either a new employee earns more than he costs, or he gets a pay cut or is fired, eventually. If he is paid less than his productivity is worth on the market, he will soon find a better job elsewhere.

But entrepreneurship has a market price, too! The entrepreneurial function is subject to the pricing effects of the market just like all other goods — just like capital goods, supplies, and labor. The entrepreneur performs the role of identifying and selecting the profitable areas of production, marshaling the other components, directing them, etc. In short, entrepreneurship is everything a firm does other than the actual labor (even if, in a small, self-owned business, the entrepreneur and the laborer are the same person).

That entrepreneurship has a market price, just like everything else. We call it “profit,” but really, it is just the component of the firm’s revenue that is attributable to the entrepreneurial functions, as opposed to all of the other components, which we call “costs.”

Workers typically expect their income to be paid in the form of prices that are fixed, and paid before the thing made goes to market and yields revenue. The entrepreneurial capitalist gets paid last. His income is variable, and thus his market price is not known until after all of the other costs have been paid and the revenue has been realized. He bears the first measure of risk that the market price for his contribution will be zero or less than zero — which usually then prompts him to find another, more valuable line of work.

Only the market price for his entrepreneurship (i.e., profitability) will tell him when to stop doing one form of productivity and start another.

Captain_Freedom January 13, 2011 at 1:00 pm

You are correct, however I must add that Reisman is speaking of the aggregate rate of profit of the economic system as a whole. He is not talking about individual businessmen earning profit.

The competition that takes place among businessmen is, according to Reisman, offsetting, in that should one entrepreneur earn higher profit, then, assuming that the supply of money and spending is held constant (ha ha! :D), this will result in a lower profit earned by other entrepreneurs. Increase the supply of money and spending, and the only difference to the analysis is that we would say “lower profit earned by other entrepreneurs…than what would have otherwise been the case”.

The reason why, according to Reisman, there always tends to be a positive aggregate rate of profit in the economic system as a whole, even though at the individual level, profit earning is offsetting, is because

1. Business owners themselves have to consume, which generates revenues but no corresponding costs in the economy; and

2. Gross investment tends to generate more revenues than costs, because while a seller of a capital good will earn the full price of a capital good as revenue, the buyer will not deduct the full amount from their income, since capital goods have a lifespan and are depreciated over time.

Reisman did not consider the Misesian “entrepreneurial profit” in his book Capitalism, which is one of Israel Kirzner’s criticisms, however I think Kirzner is a little off, because Reisman has shown that even without entrepreneurs, even without business owners making productive expenditures, even with no expenditures on capital goods or wage payments, that is, if everyone were either self-sufficient farmers or craftsmen, eking out a meager living in isolation, or in selling hand made trinkets, there would STILL be profit income in the economy, and not only that, but the proportion of income that is profits would be close to or at 100% of all income in the economy. This is because with little to no business expenditures, there would be no costs, but there would still be revenues. If revenues are earned, but no costs are incurred, then revenues are all profits. Please note that this servers to refute the common myth that higher profits are a sign of economic health. It’s quite the opposite. A healthy economy will have lots of investment expenditures relative to aggregate spending of all types, and this generates a lower aggregate rate of profit.

Gil January 15, 2011 at 7:16 am

What’s wrong with the Marx’s labour theory? In essence he’s right – a worker has to produce more than he is paid or he won’t be hired at all. Similarly, his wages are determine primarily by supply and demand moreso than his output. In a production line there can be people with different outputs yet are paid the same hourly rate.

Phinn January 15, 2011 at 7:55 am

The Labor Theory of Value is backwards. It proposes that there is some pre-existing value of the laborer’s work that, in turn, dictates the value of the article produced. The implication is that laborers are invariably underpaid.

It’s completely wrong. The value of an article is entirely subjective. It’s value is determined by its ability to satisfy a want, in light of its ordinal place in each person’s list of economic wants, and its scarcity.

Furthermore, there’s no way to know what any laborers’ productivity is worth except through a free market for labor. In a properly functioning market, they are not underpaid, but rather paid exactly what the market for labor says their labor is actually worth.

Captain_Freedom January 17, 2011 at 8:56 am

>What’s wrong with the Marx’s labour theory?

What’s wrong with Austrian subjective theory?

>In essence he’s right – a worker has to produce more than he is paid or he won’t be hired at all.

That isn’t the “essence” of Marx’s labor theory. The expectation of a profit having to exist before an entrepreneur will agree to pay wages is not Marx’s theory. Marx’s theory is that this profit represents an “exploitation” of the wage earners, who are, according to Marx, the alleged rightful owners of all output, as well as Marx’s claim that under this system, wage earner’s standard of living will chronically be depressed at “minimum subsistence” (iron law of wages).

The fact that those who pay wages require an expectation of profit before they pay wages, is something that has been known since before Marx, during Marx, and after Marx.

>Similarly, his wages are determine primarily by supply and demand moreso than his output.

This comment shows you are not only ignorant of Marx’s theory, but of basic logic as well. This comment completely contradicts the prior comment. It cannot be preceded by a “similarly”. The (correct) argument that wage rates are determined by supply and demand is an argument that undercuts Marx. It does not support it.

>In a production line there can be people with different outputs yet are paid the same hourly rate.

In a free labor market, these sorts of “deviations” from “pure and perfect competition” are eliminated over time. A productive worker who is, say, twice as productive another worker, will tend to be paid twice as much. It is to the interests of both employers and workers.

In production lines, there is a strong case to be made for why “piecework” compensation schemes can be to everyone’s interests in the company. Here, a worker is paid according to his personal output, and not a fixed wage rate. This aligns personal effort to personal wages. The more effort you give, the higher your wages will be. This principle at the individual firm level also tends to hold true in the general labor market level. Those who are more productive tend to earn more than the less productive.

Isolated cases of two workers earning the same wage rate where one worker is more productive than the other does not serve to contradict the principle of the connection between worker productivity and wages, any more than an isolated case of a company incurring losses but remaining in business for a delimited amount of time does not contradict the principle that companies that incur losses tend to leave the market whereas companies that earn profits tend to remain.

You have to think long term to think like an economist.

Beefcake the Mighty January 17, 2011 at 3:20 pm

“Marx’s theory is that this profit represents an “exploitation” of the wage earners, who are, according to Marx, the alleged rightful owners of all output, as well as Marx’s claim that under this system, wage earner’s standard of living will chronically be depressed at “minimum subsistence” (iron law of wages).”

You shouldn’t be lecturing other people on their ignorance of Marxism when you make statements like this. You’re unfamiliar with Marx’ critique of the Ricardian socialists? Marx knew full well that there was a need for capital maintenance and hence did not hold that workers are exploited because they didn’t receive the all output. You’ve never heard of his concept of “socially necessary” labor? It’s a bankrupt concept, but not what you’re talking about here.

Captain_Freedom January 17, 2011 at 5:36 pm

>You shouldn’t be lecturing other people on their ignorance of Marxism when you make statements like this. You’re unfamiliar with Marx’ critique of the Ricardian socialists? Marx knew full well that there was a need for capital maintenance and hence did not hold that workers are exploited because they didn’t receive the all output.

Ugh. And the penny drops. You have just exposed YOUR ignorance of Marxism. It seems as though you would like to lecture others on Marxism while you yourself are ignorant of Marxism.

Marx’s desire for capital maintenance is not a contradiction against his exploitation theory. They are separate. He held that in communism, where workers are not exploited because there is no private ownership of the means of production, capital maintenance is required as a matter of consumption needs. That he held workers were exploited in capitalism is due to the existence of wage labor and profit. Capital maintenance is not even related to this.

Marx in fact DID hold that in capitalism, where profits are earned, workers are exploited precisely because they do not receive all the output. This is Marxism 101. The fact that you believe the opposite is testament to your profound ignorance on this subject.

Marx defined the “rate of exploitation”, also referred to as the rate of surplus value, as the difference between unpaid, surplus labor a worker performs for their employer (meaning the full output the workers help produce) and the “necessary” labor workers perform (meaning the labor that would produce enough for minimum subsistence).

In his enquiry into the source of surplus value in Capital Volume 1, Marx claimed that the accumulation of wealth rested on the lengthening of the working day beyond what a worker needs to work to produce their own needs. In doing so, he also claimed that this constituted exploitation, that is to say, the profit a capitalist makes by means of wage labour is acquired unjustly.

Marx’s criticism of the Ricardians is irrelevant to this particular subject. His disagreements were based on philosophy and not economics.

“Socially necessary labor” was a fudge factor Marx introduced into order to reconcile his views that did not match reality, with reality.

Marx claimed:

“A use-value, or useful article, therefore, has value only because human labour in the abstract has been embodied or materialized in it. How, then, is the magnitude of this value to be measured? Plainly, by the quantity of the value creating substance, the labour, contained in the article. The quantity of labour, however, is measured by its duration, and labour-time in its turn finds its standard in weeks, days, and hours.” – Capital, Volume 1, part 1, chapter 1.

In response to the obvious refutation that his theory implies that commodities should be more valuable the more idle and unskillful the workers are who produce them, Marx states that he is speaking of “socially necessary” labor time. The “labour-time that is socially necessary is that required to produce an article under the normal conditions of production, and with the average degree of skill and intensity prevalent at the time.”

This of course means market competition, but Marx quickly forgets this. Then, to make matters worse, he contradicts himself regarding socially necessary labor time in the very next paragraph:

“Commodities, therefore, in which equal quantities of labour are embodied, or which can be produced in the same time, have the same value. The value of one commodity is to the value of any other, as the labour-time necessary for the production of the one is to that necessary for the production of the other. “As values, all commodities are only definite masses of congealed labour-time.”

Yes, it is a concept that is “bankrupt” as you say, but then again, so is your understanding of Marxism.

I mean, Marx even gives a mathematical example of how he calculates the rate of exploitation (surplus value):

“Suppose 100 pounds are the wages of 100 labourers for, say, one week. If these labourers perform equal amounts of
necessary and surplus labour, if they work daily as many hours for themselves, i.e., for the reproduction of their
wage, as they do for the capitalist, i.e., for the production of surplus-value, then the value of their total product = 200 pounds, and the surplus-value they produce would amount to 100 pounds. The rate of surplus-value,
s/v, would = 100 percent. But, as we have seen, this rate of surplus-value would nonetheless express itself in very different rates of profit, depending on the different volumes of constant capital c and consequently of the total capital C, because the rate of profit = s/C. The rate of surplus-value is 100 percent:

If c = 50, and v = 100, then p′=100/150 = 66 2⁄3%;

c = 100, and v = 100, then p′=100/200 = 50%;

c = 200, and v = 100, then p′=100/300 = 33 1⁄3%;

c = 300, and v = 100, then p′=100/400 = 25%;

c = 400, and v = 100, then p′=100/500 = 20%.

This is how the same rate of surplus-value would express itself under the same degree of labour EXPLOITATION in
a falling rate of profit, because the material growth of the constant capital implies also a growth—albeit not in the
same proportion—in its value, and consequently in that of the total capital.”

Then there are the sections Marx provides, including “Increasing Intensity of Exploitation” and “Depression of Wages Below The Value of Labour-Power” as section headings 1 and 2. Here he claims:

“The tendency of the rate of profit to fall is bound up with a tendency of the rate of surplus-value to rise,
hence with a tendency for the rate of labour exploitation to rise.”

Since surplus value and hence the rate of exploitation is defined by Marx as the difference between what the workers receive (via wages) and what they produce (via total output), it follows that Marx did in fact hold that BECAUSE workers did not receive the full output, they were exploited. That’s the whole foundation of his exploitation theory!

You better go hit the books if you presume to lecture others on Marxism. Your accusation that I am ignorant obviously rests on a psychological projection on your part.

Good luck.

Beefcake the Mighty January 17, 2011 at 11:10 pm

“Marx’s desire for capital maintenance is not a contradiction against his exploitation theory. ”

I didn’t say it was, and as is apparent from your other responses, you really need to learn to read more carefully.

““Socially necessary labor” was a fudge factor Marx introduced into order to reconcile his views that did not match reality, with reality.”

The “fudging”, of course, arises when Marx attempts to relate labor values to existing (observable) market *prices*. I presume this is what you mean by “reality”, although I would expect an expert like yourself to make this point more clearly.

I would also expect you to understand the point that, for Marx, under capitalism workers receive fair market *price* for their labor but the capitalist receives labor “power”, and *this* differential (surpulus value) is the amount of exploitation in question. (It’s not simply a question of totality of output, unless you erroneously assume 1:1 correspondence between physical product and monetary proceeds.) Of course, this differential presupposes a common unit of measurement (hence, lacking a coherent theory for relating labor values to price, one must appeal to what labor would receive under a communist society/economy), but based on your confused defenses of Reisman, I don’t think you grasp the essence of that point.

“You better go hit the books if you presume to lecture others on Marxism.”

Well, mate, you started the little lecture series here, so you might as well blow hard some more for entertainment purposes. I’m bored of you for now, I’ll check back in the morning.

Beefcake the Mighty January 13, 2011 at 1:13 pm

Reisman would benefit from reading this paper of Bagus:

http://mises.org/journals/qjae/pdf/qjae12_4_2.pdf

Captain_Freedom January 13, 2011 at 4:47 pm

>The quality of money is, consequently, defined as the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and
as an accounting unit.

With legal tender laws in effect, how is this framework relevant? It’s not like a subjectively perceived “lower quality” of money can translate into, via competitive processes, into another “higher quality” money. It can only be abandoned as such via hyperinflation where economic actors engage in a “flight into real values”.

Suppose for a moment that the QUANTITY of money is held constant over time. Under what process(es) could the QUALITY of money change, given legal tender laws?

Maybe I am missing the point of the paper, but it seems as though Bagus is using the term “quality” as a hand-maiden to what Rothbard et al already considered, which is the subjective rankings of money and goods and services. Bagus argues that if economic actors perceive the money to have a higher quality, then they will tend to increase their cash preference. OK, but what contribution is this to what has already been said? Cash preference is subjective, every Austrian already knows that.

Bagus states that Shostak was wrong to claim:

“We know that a price of a good is the amount of money paid for the good. From this we can infer that for any given amount of goods, a general increase in prices can only take place in response to the increase or inflation of the money supply. . . . Now, if the money stock did not increase, then consumers won’t have more money to support the general increase in prices of goods and services.”

I think if Bagus were to ask Shostak about this point, Shostak would say that he meant this argument to apply in the long run, *given a particular cash preference*. Given a particular quantity of money, it would be impossible for the general price level to keep increasing over time. A declining cash preference can raise prices yes, but this rise is delimited in normal circumstances. At some point, no amount of thinking “this money is terrible”, and then acting on it, can raise prices further. This is because, as Shostak noted, there simply isn’t any more money to increase aggregate monetary demand. I don’t believe Shostak was ignoring cash preference so much as holding it constant. It makes sense to hold cash preference constant because every static supply of money would carry along with it a particular aggregate demand for cash preference. It would be impossible for everyone to increase their cash balances because the only way one individual can increase their cash balance would be buy selling something to someone else, who would necessarily have to REDUCE their cash balance. Overall, the aggregate quantity of money in people’s bank accounts cannot change. If everyone tried to increase their cash balance, then you will see the effect in falling asset prices. People’s bank account would be the same, except the money used for “transactions” would be relatively smaller. The price level would settle at a lower level.

The same process holds in reverse. If everyone tried to lower their bank balances, then this would raise prices, but only up to a certain point. At some point, everyone has to have some positive cash preference, in order to conduct their daily lives, which will stop the rise in prices, and from then on, assuming no change in the total quantity of money, and assuming growing productivity, prices would then start to fall.

The quality of money is a transitory phenomenon only and does not get at the fundamentals. More importantly, the perceived quality of money, while subjective, I would argue is MOST affected by its quantity. The reason why most people considered the old Zimbawe dollars as “low quality”, and why they consider the Swiss Franc as “high quality”, is overwhelmingly affected in the long term by their respective quantities, that is, by the extents of inflation of each currency.

There is some “give” here, some “elbow room”, for sure, and for that Bagus is right to insist that subjective preferences of quality is important and real, but I don’t see how this affects Reisman’s main argument. Reisman argues that it is inflation that is the main force determining perceived qualities of money. Do you disagree?

Beefcake the Mighty January 13, 2011 at 8:20 pm

The point is that Reisman (like Shostak) focuses narrowly on the quantity (supply) of money, and not on the relevant entity, namely money’s purchasing power, which depends on supply *and* demand. This is the role of the quality of money.

Captain_Freedom January 14, 2011 at 11:19 am

That is false. Reisman does not ignore cash preference (demand for money) at all. He devotes an entire section in his book “Capitalism” on that very subject. See page 517:

“The demand for money is determined by a variety of factors. One of the most important, and, indeed, the most
fundamental, is the security, or lack of security, of property. Where property is insecure—where it is subject to
arbitrary confiscation by the government or to plunder by private gangs—saving and provision for the future
will be low, because people will not be in a position to count on benefitting from it. But such saving and provision
for the future as does occur will largely take the form of holding precious metals and gems—items easily concealable
and easily transportable. A gold money in such circumstances has a very low velocity of circulation”

In Reisman’s present article, cash preference is irrelevant to the question of where profit fundamentally comes from. This is because it is not liquidity preference, nor cash preference, nor demand for money, that ultimately, and fundamentally, generates economic profits.

As Rothbard emphasized, when one considers demand for money, or “hoarding”, one must always keep in one’s mind the fact that it is an error to assume that a reduction in spending/transactions would take place in one specific area of economics only, for example consumption spending, or investment expenditures. He argued that it is important to realize that it is *time preference* that determines economic profits. If people hold more cash, for whatever reason, and if their time preference does not change, then we must conclude that an increase in cash preference will result in a reduction of both consumption spending *and* investment expenditures, in amounts that will leave the resulting ratio, the difference, unchanged. This difference is, of course, what generates profits.

It seems as though you just read this paper by Bagus, and are now trying to force it into a critique of whoever you think is ignoring it. That’s good, but I would suggest that you focus your energy here on critiquing those who ACTUALLY ignore it. Look to the mechanistic monetarist types, or Keynesians, if you want a good place to use Bagus’ arguments. It is irresponsible to use it against those who are not actually guilty of ignorance on this topic. I have shown that Reisman does NOT ignore cash preference. I have already argued that if Bagus were to ask Shostak, Shostak would accept that the demand for money is a valid, real world concept, and so I don’t think it was proper for him to cherry pick one quote from Shostak, without at least appearing to show any further knowledge of Shostak’s writings.

Beefcake the Mighty January 14, 2011 at 5:19 pm

Perhaps I should have stated it more explicitly, but I did not mean to imply that nowhere in his body of work does Reisman discuss the demand for money (and his book is not really under debate here). He clearly does not (as you admit) attribute an important role for it in the origin/determination of profit, and this is quite wrong. The important point, again, is the purchasing power of money, and here (also listen to his talk from the Austrian Scholars Conference from 2005, I think; Kel Kelly references it in one of his online articles here) he focuses quite narrowly on the quantity of money.

Captain_Freedom January 17, 2011 at 10:10 am

Again you are misrepresenting Reisman’s position.

It is not “quite wrong” to not consider “the demand for money” as a component in the origin/determination of profit. You have not even shown any argument at all as to *how* the demand for money, by itself, affects the origin/determination of profit.

Again, I highly suggest that you read not only Reisman’s arguments, but Rothbard’s arguments as well, because you are conflating two very different concepts. The demand for money DOES NOT affect the origination of, nor the determination of, profit. For Rothbard, it is *time preference* that directly creates and determines profit. For Reisman, it is net consumption plus net investment which is the proximate cause for aggregate profit. Insofar as the demand for money affects one of these two components, then Reisman holds the aggregate rate of profit will change.

Reisman does consider changes in the demand for money and its effect on profit, but he does so *indirectly*, through its effect on net consumption or net investment. He deals with “hoarding” and its long term effect on the rate of profit, on page 837. He notes that “hoarding” serves to raise the rate of net consumption in the long term, which makes aggregate profits rise. He also deals with a decreased demand for money holding, and gives numerous reasons why people would want to hold less cash. And again, he argues that this decreased change in the demand for money holding can only affect the aggregate rate of profit insofar as the change in demand affects net consumption and/or net investment, for these are the *proximate* factors of aggregate profit. If net investment is unchanged, or if net consumption is unchanged, then a change in the demand for money will not affect the rate of profit.

You keep insisting that “it is wrong” to not take into account purchasing power of money here, but you have not at all shown this.

It is wrong to completely ignore the demand for money in general, but it is not wrong to ignore it when discussing the origin and proximate determination of profit. For Reisman, a changed demand for money will only affect the rate of profit if it affects net consumption or net investment, which in other words means the demand for money by itself does not affect the rate of profit at all. Rothbard holds this position as well, although he argues it in a slightly different manner.

Profit is ultimately determined by a difference between the subjective valuation of future goods as against present goods. This is the quintessential Austrian position, so if you want to attack this, then you have to at least show you understand the positions of those you are attacking. You have not shown that you do know.

Profit originates by selling goods for money after incurring money costs that are lower.

The demand for money does not, by itself, create nor affect profit (things get complicated in a fractional reserve monetary system, which I won’t go into here). If people decide to hold more money as cash, or less money as cash, then, as Rothbard has shown, as long as people’s *time preference* is unchanged, then the rate of profit will not change. He showed that if people want to use less money in trade, and hold more as cash, or vice versa, then they are not obligated to only take away from their consumption spending, which, when coupled with an unchanged amount of investment expenditures, will reduce profits. For this would represent a *decline* in the rate of people’s time preference, as people would be spending relatively more for future goods (investment), and relatively less for present goods (consumption). That is why profit falls here. It is time preference that is the proximate cause.

If on the other hand people’s time preference is unchanged, and they hold the same difference in subjective valuation between future goods as against present goods, then an increase or decrease in the demand for money will result in BOTH consumption and investment expenditures falling or rising TOGETHER, in the same ratio, which will leave the difference the same, and thus have no effect on the rate of profit.

For example, if we hold all else equal (meaning hold time preference the same), and imagine that people spend 1000 on consumption goods and 800 on investment factors (wages, equipment, depreciation, etc), which generates a profit of 25% (200 profit on 800 capital), then Austrians argue that the rate of profit is determined by people’s time preference, that is, by the difference between future goods (800 spent now) and present goods (1000 spent later), which is 200, which is 25% profit on 800 capital.

If we now suppose that the demand for money rises, then, again holding time preference constant, what will happen is that BOTH the 1000 consumption spending AND the investment spending will fall in the same ratio as 1000 to 800 (or 5 to 4). If people want to hold say 180 units more money as cash, then out of this 180 increase in money holding, there will be 100 less consumption spending, and 80 less investment expenditures. The net effect after the increase in money holding is that consumption will decline to 900 and investment expenditures will decline to 720. The rate of profit after the increase in demand will remain 25%, since (900 – 720) / 720 = 25%. This 25% profit is determined by time preference, not the demand for money. This is Rothbard’s position.

For Reisman, the reason why the quantity of money is fundamental to the general or aggregate rate of profit, and not the demand for money, you need to realize that the aggregate rate of profit is determined by current aggregate revenues minus current aggregate costs. Current aggregate costs, of course, are a function of aggregate expenditures made in the PAST. The more investment expenditures made in the past, the higher current costs will tend to be, and vice versa. Current aggregate demand, of course, is a function of present aggregate demand. It is “instant”, so to speak.

If the quantity of money rises, then, assuming the same rate of time preference, this will increase the aggregate rate of profit. This is the case IF ANY of the additional money is used in any way at all, because this process serves to raise aggregate demand as such in the present. If the new money is used to buy more labor, more capital goods, more consumption goods, more of anything, again holding time preference the same, then what will happen is that current aggregate revenues will rise instantly, *but current costs will not rise instantly, since current costs are a function of expenditures made in the PAST*. It is not until some time passes that the additional demand for factors of production taking place now will raise the costs of business firms. It cannot be stressed enough that at which time costs do in fact rise on account of a higher aggregate demand for factors of production (which was caused by an increase in the quantity of money now), there will almost for certain have been more inflation in the interim. After all, central banks do not inflate in spurts. They continually inflate over time. If central banks increase bank reserves such that the quantity of money rises at a 3% annual rate, then this will tend to add 3% to the aggregate rate of profit.

Anytime an economy experiences an external additional monetary demand for goods as such, this will serve to enlarge the spread, the difference, between aggregate revenues and aggregate costs. The reason for this is as that, as shown, costs rise with a time lag, whereas revenues rise more or less instantly, when inflation takes place.

To fully cover Reisman’s position on the demand for money, so that you can stop making false accusations, I suggest that you actually read his book. He does in fact deal with demand for money, but he deals with it indirectly, by looking at its effects on net consumption and net investment. If you show how a changed demand for money can affect net consumption and/or net investment, then you will only be doing what Reisman already considered in his book.

Beefcake the Mighty January 14, 2011 at 5:33 pm

See the discussion here:

http://blog.mises.org/14678/what-drives-profits/

Reisman’s point that interest is fundamentally a *monetary* phenomenon is a brilliant one, but again, he errs in not identifying the purchasing power of money as fundamental.

Captain_Freedom January 17, 2011 at 10:15 am

>See the discussion here:

>http://blog.mises.org/14678/what-drives-profits/

You made the same errors in that discussion.

>Reisman’s point that interest is fundamentally a *monetary* phenomenon is a brilliant one, but again, he errs in not identifying the purchasing power of money as fundamental.

You have not shown where Reisman erred. He does consider changes in the demand for money, but only indirectly, insofar as it affects net consumption and/or net investment, which then directly affects the rate of profit. He does not hold demand for money as fundamental because it is not in fact fundamental. Changes in the demand for money by itself does not necessarily affect the rate of profit. It will not change the rate of profit if time preference does not change.

Captain_Freedom January 18, 2011 at 9:01 am

Since your last ugly post re: Marx above did not contain a reply option, I will reply to you here.

>I didn’t say it was, and as is apparent from your other responses, you really need to learn to read more carefully.

This is getting downright ugly. You are so ignorant.

I never claimed you said it was a contradiction. I said it is not a contradiction in order to make you realize that capital maintenance and worker exploitation are SEPARATE concepts in the Marxist framework. It is now crystal clear that not only do you not understand Marx’s theory, you also can’t even keep your own thoughts in order. You claimed:

“Marx knew full well that there was a need for capital maintenance **and hence** did not hold that workers are exploited because they didn’t receive the all output.”

This is a false claim, because the need for capital maintenance does not have any consequences for the content of Marx’s worker exploitation theory. There can be, according to Marx, capital maintenance in communism, AND workers will allegedly not be exploited either. In other words, the validity/invalidity of his exploitation theory does not follow from capital maintenance.

>The “fudging”, of course, arises when Marx attempts to relate labor values to existing (observable) market *prices*. I presume this is what you mean by “reality”, although I would expect an expert like yourself to make this point more clearly.

In the real world, we observe prices. That should have been obvious. There is no need to make “prices” explicit here, if one understands Marx. My guess here is that you are desperately trying to now show some semblance of understanding Marx and so you want to add a relatively inconsequential quibble that is not even necessary to the context in order to appear knowledgeable about what you have now been exposed as being completely ignorant.

>I would also expect you to understand the point that, for Marx, under capitalism workers receive fair market *price* for their labor but the capitalist receives labor “power”, and *this* differential (surpulus value) is the amount of exploitation in question.

This makes no sense, and is not what Marx wrote. Marx did not argue that workers received a “fair” price for their labor. He held that what workers received to be UNFAIR.

Marx held that workers will ipso facto receive minimum subsistence (iron law of wages). He also held the contradictory view that workers are *progressively impoverished* in capitalism. Surplus value is, according to Marx, the difference between what workers produce for their own minimum subsistence, which is allegedly what they will receive, and the output they actually produce for their employer.

>(It’s not simply a question of totality of output, unless you erroneously assume 1:1 correspondence between physical product and monetary proceeds.) Of course, this differential presupposes a common unit of measurement (hence, lacking a coherent theory for relating labor values to price, one must appeal to what labor would receive under a communist society/economy), but based on your confused defenses of Reisman, I don’t think you grasp the essence of that point.

You have not at all shown where my arguments are “confused”. It is perfectly clear that you are either a troll for kicks, or you actually believe your ignorance concerning both Marx and Reisman can substitute for sound knowledge.

>Well, mate, you started the little lecture series here, so you might as well blow hard some more for entertainment purposes. I’m bored of you for now, I’ll check back in the morning.

No, actually it was you that started the discussion between you and I. I sent a response to Gil, and then you stepped in and have done nothing but send incoherent, uninformed, and crude posts to me. Since then, I have only corrected you the entire way.

Allen Weingarten January 14, 2011 at 6:27 am

“the wage earners will use their higher wages to make additional purchases from business firms…”

Let us assume that a car producer provides 500 cars a month, but gives workers extra pay to buy more back, for which they spend all their extra wages. Then, there are 600 cars produced, where the extra 100 cars are sold to those employees. This gift of extra cars has earned no more profit, but has cost the producer for providing them. Whether it is cars, donuts, or shoes, the gift to employees of those goods is not a profit, but a loss. Nor is it any different to the producer than if he gave the extra 100 cars to anyone else, or threw them in the river.

The reduction in profit renders them less competitive to the other car producers who do not give that gift, and less competitive to other industries (since competition occurs across different industries). Even if all industries bestowed comparable gifts, there would be no increase in profits, but only employee benefits that violate the supply & demand activity in the market. So what is presented as improving the economy is a recipe for violating the optimization of the use of resources provided by supply & demand.

Captain_Freedom January 14, 2011 at 11:47 am

>Let us assume that a car producer provides 500 cars a month, but gives workers extra pay to buy more back, for which they spend all their extra wages. Then, there are 600 cars produced, where the extra 100 cars are sold to those employees. This gift of extra cars has earned no more profit, but has cost the producer for providing them.

Yes. I think your example would be even better expressed when dollar amounts are used, rather than physical units only.

If the first 500 cars cost $5,000,000 in total to make (including depreciation, operating expenses, wages, etc), and the cars each sell for $11,000, then the revenues earned are (500 x $11,000) – $5,000,000 = $5,500,000. Rate of profit is ($5,500,000 / $5,000,000) = 10%.

If the car company owners increase wages so that the workers can buy 100 more cars, and we assume the selling price remains the same, then the company will have to pay them *at least* 100 x $11,000 = $1.1 million more in wages.

This will result in the company earning an additional $1.1 million in revenues. What about costs? Here is where we can see the company incurs a loss. Those $1.1 million in additional wages will of course generate $1.1 million in additional costs to the company, but wage costs are only ONE of many costs the company incurs when selling each car. The company incurs depreciation costs, materials costs, administrative and selling costs, energy costs, and everything else not wage related. This of course means that those additional 100 cars are sold at a loss.

Your example is doubly effective, because not only can it show that a company will incur losses even if their workers spend ALL their additional wages on the company’s products, but the losses will be even more severe if the workers do what they will almost certainly will do in reality, which is take their additional wages and buy products from other companies. After all, the average wage earner does not buy everything from one seller, but from many different sellers.

This also serves to show why unemployment was so high after the 1929 crash, when the Hoover administration and the nation’s top businessmen “agreed” not to lower wage rates for employees. They mistakenly believed, or, what I think actually happened, which is that the top businessmen were “nudged” by Hoover to “accept”, that paying workers more money will result in the company owners earning more money for the products they sell. Of course this “enlightened” policy proved disastrous.

Captain_Freedom January 14, 2011 at 11:51 am

Correction:

If the first 500 cars cost $5,000,000 in total to make (including depreciation, operating expenses, wages, etc), and the cars each sell for $11,000, then the revenues earned are (500 x $11,000) = $5,500,000. Rate of profit is ($5,500,000 / $5,000,000) = 10%.

billwald January 14, 2011 at 8:19 pm

Right, correct.

Unprofitable companies go broke and so write themselves out of any discussion on profits.

Say the company was a co-op and the profit was (theoretically) zero. Would anyone connected with the company be worse off?

Why don’t credit unions and mutual insurance companies put the for-profits out of business? Because the non-profits have a lower productivity per employee?

Most of the profits in the last 60 years came from increased productivity. For the first 25 or so years the workers got 80% of the net increase and most every year most people did just a little bit better. in the next 20 the owners realized THEY could keep the 80% and the every year the American worker did a little bit worse. In the last 10 years the owners learned they could do much better if they sent jobs off shore. Glad I’m retired.

Allen Weingarten January 15, 2011 at 3:33 am

Captain_Freedom, thanks for your comments, which are a better explanation than mine. However, the reason I avoid a more complicated description is to reach those of us who think in simpler terms. Here, when I ask people (including Democrats) whether a donut company that gives away a batch of donuts increases their profits, most say “Of course not.” To those few who say “Yes”, I respond “Great, let them give away ten batches.”

My view is that the Austrian economists are often out-competed by the Keynesians because the latter provide a simpler and briefer description, that is even comprehended by high school dropouts.

Captain_Freedom January 17, 2011 at 10:20 am

>My view is that the Austrian economists are often out-competed by the Keynesians because the latter provide a simpler and briefer description, that is even comprehended by high school dropouts.

You may be right, considering how I made a mathematical error using the more complicated method. KISS should have applied to me I guess :/

DTR January 14, 2011 at 5:09 pm

Check this out http://www.gutenberg.org/cache/epub/7213/pg7213.html It’s Henry Ford’s Autobiography… Ford has an interesting and realistic explanation of why paying high wages pays, look at chapter called Wages… I think that sometimes economists look human beings as a cost, but are we really a cost? Then Who produces wealth and profit???’

Joe January 15, 2011 at 5:29 pm

DTR, I found the article to be very interesting. Henry Ford was a pioneer in the field of business. I was surprised to find that he used “method engineering” to determine the proper wage rates to pay his employees. I used to be a methods engineer with a large bank in California and we did the same thing that Henry Ford describes. He did find the cost of each individual job being performed. It is because he knew the cost he could now plan and pay his employees at a greater wage. He also understood that his “turnover costs” were costing him money. So when he started to pay his employees at a 15% higher rate than his competitors he was able to drive down his turnover costs. The key to what Henry had to say is, based on my opinion, the more productive and efficient you become the greater the rewards to the workers and the company as a whole. Henry had an advantage on other competitors because of his scientific approach to determining his actual costs. Alcoa also was another company that had a “natural monopoly” because no one could compete based on costs and quality product. But lo and behold the federal government decided that they were a monopoly and unfair. So another causually of the anti-trust legislation. The only people that got hurt were the consumers because now all the inefficient competitors that went to the government trough drove up prices and lowered quality because they were given a piece of the pie through coercion.

Comments on this entry are closed.

Previous post:

Next post: