Defending the idea of profit will, in these enlightened days, immediately split the room. If you follow politics in the US, watch how campaigners Bernie Sanders and Elizabeth Warren masterfully attach emotional adjectives to capitalist nouns such as “massive profits” enjoyed by “ultra-wealthy families”, or the “huge profits” going to “already-wealthy shareholders”. Is there any way for profit to escape its biblical “filthy lucre” lineage?
As accountants we define profit as the positive difference when revenue exceeds costs, but this misses the mark. Profit is not only a guiding force in the market economy, but more importantly the result of a society based on an ethical principle — customer sovereignty.
To truly understand profit, you have to understand the concept of economic value, and a good way to think about this is the idea of substitution. The world is finite and we live finite lives. That presents an optimisation problem. Do I work for this company or study a law degree? Should I drink tea or coffee? Mentally, we appear to maintain a league table of preferences, ranking all manner of things. To choose one thing is to give up another. Netflix or pizza? New washing machine or save for the kids’ education?
This subjective view of customer preference was the insight of the Austrian school of economists. Unlike Adam Smith and Karl Marx, who said things cost what they do because of the labour involved, Ludwig von Mises and Friedrich Hayek showed it is customer sovereignty that chooses what is valued in the world. They demonstrated how the calculus of a billion daily purchases proclaims our collective mental preference for how the world should be organised; fettuccine over Faust, now before later. Through these rankings the world derives the cost of things.
It is the entrepreneur’s job to decide whether the things we find in the world are best left as is, or whether they can be combined into something new. There are multiple solutions to the same product and entrepreneurs solve that problem by changing raw materials, the organisational structure, and combinations of capital and labour. And here’s the cool part: the market reveals to us which combinations work and which do not. Through the system of prices we learn whether the market would rather leave something as it is or forge it into some other combination to create a new thing. To use or not to use, that is the question.
Take bread. The ingredients are flour, yeast and labour. Before the baker applies his skills, customers around the world have rank-ordered the raw materials and in the aggregate we know their worth relative to everything else. After the baker kneads his dough and applies the heat, we have a new combination in the world; a loaf of bread. The question is whether the customer is prepared to pay more for the loaf than he would have for the raw ingredients. If he does, the baker makes a profit. If costs exceed the price we draw a powerful conclusion; the customer would rather the entrepreneur had done nothing, because the materials were valued more before than they were after. Profit is the signal of value creation. Crucially, accounting loss indicates destruction.
A little-understood consequence of this powerful idea is what happens when two suppliers draw upon the same resource. Say Baker One increases his profits by combining flour and labour in such a way that he needs less yeast. The increase in his profits shows he is drawing fewer resources from the world. Better than that, with reduced demand for yeast, Baker Two now bakes his bread from a reduced cost base and also increases his profits. A technology innovation in one business leads indirectly to an increase in profits in another.
Entrepreneurs are in a constant discovery process, evaluating the world as they find it while contemplating its alternate use. The market system rewards those who draw least from the world. Taken to the extreme, the entrepreneur who produces product ex nihilo (with zero costs) not only maximises profits but is also the ultimate environmentalist! As an aside, those who make the largest profits are often the ones best positioned to value the world “as is”. Ted Turner used the profit from a television network to buy almost a million hectares of land to leave to his bison herds, which now make up 11% of the world’s population.
Unfortunately, governments too often think they can improve on the market process, and in doing so undermine customer sovereignty. Profits are labelled “windfall” and therefore undeserved. Regulation imposes methods such as “cost-plus” pricing, which are exceptionally damaging to the overall process. In our previous example, the entrepreneur achieved higher profit by lowering his input costs. In a cost-plus model, such as Eskom, the incentive is to increase one’s cost base to demonstrate to the regulator the need for an increased consumer price.
On the investment side, profits are an indicator that something is in high demand. They send the right signals to entrepreneurs that other alternatives should be abandoned and that what is needed today are 5G cellphone masts, or more renewable energy. Cost-plus models destroy these signals, causing underinvestment in these markets and reduced customer satisfaction.
A paying customer demonstrates what a problem is worth, and indirectly sets a price on the world’s resources. An economy built on customer sovereignty will allocate those resources to the things people value most. The entrepreneur’s job is to seek out the endless combinations of labour and resource, organising the world into new constructions. By maximising his profit he creates the most value in the world and takes least from it.
Or, to put it simply, the product created should be valued more than the sum of its parts, and this value is labelled “profit”. The opposite is destruction. Profit is the market’s way of saying “Thank you! Keep doing more of that.”
• Emerick is an associate of the Free Market Foundation.
This article was first published on Businesslive. on 8 January 2020