When profit is a problem

After this post, my quest to grasp heterodox economics moved on to this Crooked Timber thread, in which Dsquared argues that the biggest problem with orthodox economics is that it doesn’t really account for profits. And profits are a pretty big thing to miss, especially as the entire notion of economics relies on the idea that firms maximise their profits. (Consider competition – how would you know if you were competing successfully if you didn’t make or lose money?)

However, standard assumptions include the idea that no-one makes more than the amount of profit they need to keep them from going and doing something else, so-called normal profits. (If they made more profit, more competitors would pile in until the rate was reduced.) As the general alternative to production is to keep your money in the bank, it’s argued that therefore normal profits equal the cost of capital, i.e. the rate of interest.

But, as Dsquared points out, nobody thinks that a company that only covers its cost of capital is doing well.

The upshot is complicated, but it raises all kinds of curious issues. For a start, if there are no profits in a capitalist system, how do we account for economic growth? In a sense, once you decompose growth by factor and strip out one-time factors (population change, digging up more stuff), what you’re left with is the economy’s aggregate productivity gain plus the product of the net change in capital stock (which is after all the share of past income that went into investment).

More importantly, how do we account for change over time? Schumpeter argued that supernormal profits existed in the short and medium term as a result of asymmetric technological progress – they were the return to innovation, which created a temporary monopoly rent before further technological change destroyed it. This explanation – the principle of creative destruction – is intuitively sensible, logically coherent, explains the presence of profits and long-run growth. It also justifies the existence of profits and quasi-monopolies, which is handy.

What if there were no profits in reality? It’s hard to answer this without tripping on definitions. Assume a company in which the management aims to break even, and any surplus is paid out in wages. There is no official profit here, but it’s clear that the company will still try to maximise its surplus. In fact, it may well try harder – everybody’s interests are aligned, no? It will also try to compete with other firms, to take a hard line with its bankers and its suppliers, and try to keep its margin up on sales. It is likely to rent-seek with regard to everyone else but its own employees. The story is not that much different if the surplus is to sink into its trading partners, so long as they have means to hold it accountable.

Oddly, getting rid of profit doesn’t change the picture very much. That’s because we haven’t – we’ve just shifted it from the capital share of GDP to the labour share. One thing that has changed is economic rent – changing the factor that benefits changes who the firm can gull. Clearly, the difference between profits that arise from economic rent and from value-adding is going to be important. But that’s even harder to define – in Schumpeter’s terms, of course, having a new productive technology before anyone else allows you to collect a monopolist’s economic rent, even though you’re adding value by deploying it.

Around this point a lot of people in the past have tried to draw a value judgement, a distinction between the return to “healthy”, “good” improvements in productivity, and “bad”, “exploitative” rents. Unfortunately, this is one of the points at which people start to go crazy; the distinction between raffendes and schaffendes Kapital (“robbing” and “creative” capital) was a favourite of German proto-fascist and indeed fascist economists, who tended to associate the first category with Jews, Freemasons, international bankers etc, and the second with their favourite armaments industry tycoon.