The Function of Profits

0:00This is Jeffrey Tucker with our continuing series on Economics in One Lesson, the new edition from the Mises Institute, and we're here talking today with Joseph Salerno from Pace University, recovering two chapters, The Function of Profits, and then we get into to an issue that's particularly important to us today, inflation. Welcome, Joe. Thank you, Jeff. So, let's talk about the function of profits. What is the chapter about? Chapter basically points out that profits are a very small component of national income, but they're the most important component because they're what motivates production.

0:48They're what motivates people to risk their livelihoods in order to attempt to forecast of the Future and Future Consumer Needs and to take the steps necessary to adjust production, to come up with new ideas, new types of goods, new qualities, better qualities of goods and also to relentlessly lower the cost of producing goods through the application of newly discovered technology. But now, when you say motivates, what if an entrepreneur says, you know, I really just don't care that much about profiting, what do you mean when you say motivating? Profit is an indicator of success. Many entrepreneurs like Bill Gates, Sam Walton, Ray Kroc, if you read their biographies or autobiographies about them, they weren't motivated simply by money. They were motivated by a need to more or less actualize the vision that they had of a company that was serving consumer needs. So that's not to say necessarily they They were altruistic, but they were creative geniuses in a way that needed to actualize a vision that they had of producing a new good, or a better good, or a good at a much

2:00lower cost, in the case of Sam Walton and Wal-Mart, cutting unnecessary costs, getting rid of all inefficiencies, and bringing products that consume at low prices. So you're distinguishing between a profit motivation and a money motivation. What do you mean by that? Profit motivation is what motivates the entrepreneur in the sense that the entrepreneur is continuously scanning the market for undervalued resources, and then with the intention of combining them and then bringing them to market in a much higher valued product. So this is the motivation of the entrepreneur. So the profit serves then as a signal that he's done the right thing, that he's doing Find the right thing as a sign to indicate possible future actions just as a way of sealing up their good work.

2:51Yeah, absolutely. It does signal success in what they've done, but they can't keep that success to themselves. That's the other thing. Profits are a signal in some sense, and they grab the attention of other entrepreneurs who want to emulate these entrepreneurs and similarly earn a profit. And quite often these profits are not just put into yachts and big boats and things like that, but turn back into the company. If you're going to expand, you have to have a profit rate. For example, Sam Walton was continuously plowing his profits back into his firm. For example, he himself had a rule for all people crowdily on company business. They would always share a hotel room. And when he traveled, he shared hotel rooms with one of his employees.

3:38You know, it's an interesting thing that if you can imagine a world without profit, you would have a world where business just continued to do the same thing. I would say there were neither profits nor losses. You would have to just have a completely static economy. It would be a very stagnant economy. It would be a static economy. Actually, that's the definition of a static economy. An economy where there's no profits or losses. People can be changing their demands and firms would be changing products, increasing some, decreasing others, In the last quarter, Ford lost $8.7 billion because they were producing SUVs and trucks that were not adjusted to the price of gasoline so people were reducing their demand.

4:42Signals of a business mistake. Yeah, that signals a business mistake. A waste of resources. They are using resources that have a higher value to consumers in other areas than the product that is being produced. Yeah. So, if you were going to construct a system that said, well, you know, we need some kind of system in which people that are using resources efficiently and serving others and other factors need to be somehow rewarded so they can continue to do that at a more expansive level than they had done before. You've put together something like the profit system. Yeah, that's what would come out of that speculation if you thought about it. But no one mind can reproduce that in any sense. So that's why public ownership or collectivist ownership under socialism can never work because they can't really construct this very sensitive network of profits and losses.

5:31Who was it that said cost accounting was the greatest invention in the history of the world? That was Ludwig von Mises, because this is what allows a businessman to oversee all his operations to reduce some areas, to get rid of some of his managers that are not adjusting to the conditions according to his own plan that he lays out for his whole business. And there have been socialist systems that attempted to replicate the profit-loss system. Yeah, that's true. They use phony prices or they copy the prices that they see on world markets so they can crudely calculate in some sense in the real world.

6:24But no socialist system has actually used prices that were developed through a computer or through a trial and error method. There were many theories in the 1930s that the socialist society could replicate the market price system. But that's already admitting, of course, that you need prices. But what they could never do is replicate profits and losses. Socialist businesses don't go out of business. Well, I suppose part of the problem is that just because you made a profit today or this week or last month or last year doesn't really tell you anything for sure about the future. That's absolutely true. IBM dominated the computer industry in the 1970s and now they're simply a minor player in the computer industry. You can think of the big three automotive companies in the US dominating auto production into the early 1980s and now all three of them are losing large amounts of money and GM is cutting workers and Ford is closing down plants.

7:21When a businessman looks at his accounting sheet and sees profits, it seems like it's a ratification, only that in the past you've done well. But it doesn't give you any indication of what's going to happen in the future. It strikes me that the whole thing is relentless. The whole project of enterprise, the productive enterprise is relentlessly terrifying. It's a good word, it is relentless. There's a selective process going on that weeds out those people who are not currently serving consumers. And it's done by consumers abstaining from buying certain products and increasing their purchases of other products. It is relentless and it takes no view of the past. It's concerned with what is going on right now, am I being satisfied by these products right now?

8:12And does the more profitable enterprise have, in some sense, an advantage, the large business have an advantage over the small business in this respect? No, not at all. In fact, again, the person who earns the profit is the person we call the entrepreneur, and the entrepreneur can always come up with new ideas, and these can be hatched, these new ideas in garages, as Apple under Stephen Jobs was. And Apple came came from nowhere to out-compete IBM in personal computers, and Microsoft similarly came with operating systems, it was a tiny company which exploded because it served consumers, so exploded with success is what I was intending to mean there.

8:58And so a big company, unless it has some kinds of government regulations and privileges, cannot continue its success without continuously changing its products according to consumer demand. Profitability becomes more and more difficult too with the large business because you've got ever higher costs. Right. Your costs are higher, you have higher sum costs, you're not as nimble, you're not as flexible, you can't move around as quickly, whereas a new business can easily adopt a new technology and can change its production in a moment's notice. And it must be especially difficult nowadays with technology constantly moving forward, all the time. And if you get attached to a certain way of doing things that's profitable, you think, well, we just need to do that again. And you wake up the next day and everything's different and your competitors are using something that does twice as much work at half the cost.

9:47That's right. Yeah, you often hear about an entrenched corporate culture, a certain culture, and some people hold this up as being good, but the fact is the culture has to change according to consumers' demands and according to technological conditions and cost conditions. So how do these large businesses keep up? I suppose the cost accounting is always the signal. It is always the signal and the past always does give them some information about experience and then they judge this, they analyze it and they try to extrapolate and forecast consumer demand in the future, technological conditions in the future and so on. Now we're speaking about profit as if it's just one thing but there's a range of profitability right? And the more profitable industries will tend to inspire others to emulate them, right?

10:38Yeah, that's true. You'll have, as we had with the high-tech industries, expanding and becoming more profitable, even as prices have fallen and there's been a tremendous expansion in their output. The first personal computer was $20,000 in 1980. We can now get personal computers for $500. The shipments were half a million in 1980. By 2000, even though the prices were much lower, they were producing and shipping something like 11 million units. You know, I think about this all the time because, just as our own internal example, which is just minor and totally completely petty, but you know that for years people were advocating that the Mises Institute have small flash disks that were customized, so the Mises Institute looked into the prices and I was terrified to buy them in January, Because you have to buy a certain quantity. I thought, how many of these things can I sell?

11:29By the fall, you know, and, well, six months later you looked at the cost of these things and they had fallen by half. And then a full year later they were really 10 percent. Now, if we bought that inventory at the beginning and not sold it, I mean, that's just a potential disaster waiting to happen. I don't frankly understand how these companies can do this. But it's just, as you pointed out before, it's the fact that the competitive process driven by profit motivation is relentless. And one way to make profit is to continually lower your cost on the same product that you're producing. So this is why we have a continual fall in prices in the high-tech industry. You know, I think we tend to think of entrepreneurship as a one-time thing. You know, like somebody has an idea, here's a product people are liking, you come up with it, you market it and it sells.

12:17But it's really, it's a daily thing, isn't it? It absolutely is. You're continuously fine-tuning the product itself and the pricing process that you're using, the pricing procedures that you're using, the price of product. You can look at the airlines where prices are continually changing, they're continually changing the space between the seats, what they're feeding you and so on. Yeah. I suppose that you have to have a certain kind of personality to thrive on that kind of relentless roiling around every day, that sense of uncertainty and terror, really. You have to be willing to risk your livelihood and even your destiny with the very optimistic expectation that you can do better than your rivals in serving consumers.

13:02And so, entrepreneurs are fundamentally optimistic, and some of them may be overly optimistic, but that is one of their important traits. So not everybody is capable of this, and it's a selective portion of the population, and the benefactors really to the rest of us. The next chapter concerns the issue of inflation and maybe as a segue you could just mention we're experiencing some inflationary times right now focused on particular sectors, you know, oil and other things but everything. How does this affect, how does inflation affect doing business? Inflation falsifies cost accounting because when the entrepreneurs look around they see that prices have risen and that their costs which are recorded at their historical levels are much lower so they seem like they have profits but these turn out to be paper profits because they have to replace these raw materials and the machinery and so on at much higher prices later on and so inflation causes a misallocation of resources, in fact it causes the

14:01consumption of capital as people begin to spend these profits on consumption goods rather than then put them aside with the intent of spending them on replacing their capital at higher prices And why would it bias us towards consumption as opposed to... Because, as I said, profits look much higher. Because the costs are things that are recorded at pre-inflation prices. There's a conservative bias in accounting, which records costs at the historical level. So when inflation breaks out, prices are the first thing to rise, and entrepreneurs see higher profits. And they might plow some of this back into their business, But in fact they have to put all of it back in to take account of the fact that the costs when they replace these inputs are going to be much higher.

14:51Then they have to worry about selling prices, right? In what sense? I mean, then they have to raise their prices for consumers and they don't know how that's going to affect the demand for the product. Well, exactly. With inflation it's called, it's ragged or uneven. That is, some prices are affected more than other prices. And at times, some industries will suffer in inflation. That is to say, the money that's being spent on their industry will not yet lag behind the spending on other industries. So they will not be able to raise their prices as quickly as their costs are going up. So they will be squeezed and they'll have to reduce production. Now, the way you tell the story, it seems inevitable that you would tend to see decreased Production and Greater Numbers of Business Failures in an Inflationary Environment.

15:40But that hasn't always been the macroeconomic theory, right? Can you account for that and explain how it is that economists came to believe that inflation was compatible with fast economic growth? Well, there's a naive view, and the naive view is that anytime you print more money and there's greater spending in the economy, well, then we have greater wealth, greater Money wealth, and that's sort of just an illusion, of course. In order to have greater prosperity in the economy, you have to have more goods. And more money does not automatically bring forth more goods. But the more sophisticated view is that there's always a margin of unemployed resources and that increased spending will bring about a situation in which you'll raise some prices and that will make it more profitable to hire the unemployed labor to utilize the The Unused Factory Space and so on.

16:35And that will then create prosperity. So in the second more sophisticated case, they don't focus on printing a lot of money and just driving prices up. They focus on filling a deflationary gap. That is that spending is just falling short of the potential output of the economy at going prices. So you want to raise spending moderately to allow all the goods that are being produced to be purchased by consumers and by investors. Inflationary recession is not so much an anomaly, it's something you would just tend to expect. At some point when prices begin to rise at rapid rates, rates that are politically unpopular or that the Fed does not want to continue, the Fed will stop inflating at that rate of increasing the money supply at that high rate, will cut back, interest rates will rise and prices of investment goods will begin to fall and we'll begin to see firms going out of of Business, laying off workers, mainly in the capital goods industry. But you'll still

17:33have prices rising of consumer goods because all the money has not been percolated through the economy. So you'll get an inflation as well as a recession. And that's known as the Austrian theory of the business cycle. Or so-called stagflation. Yeah, stagflation. And how do non-Austrian schools account for stagflation? Non-Austrian schools will account for stagflation as a result of an exogenous shock, what they call a shock from outside of the Economy. All of a sudden oil prices rise, so costs are higher, firms then produce less good so you have a recession, but at the same time prices are going higher because the prices of the inputs are higher. So they posit these sort of outside shocks that suddenly cause these losses in the economy and reduction in output. Higher food prices for example is another example of or another way in which the economy can experience a stagflage.

18:24That doesn't sound like a very systematic theory at all. It really isn't. It's really an ad hoc theory to explain what happened in the 1970s, beginning of the 1970s. Now, Hazlitt was writing this book in 1946. What was happening in terms of inflation in 1946 that caused him to zero in on this issue? Well, we had had price controls, as most wartime economies do, throughout World War II. And there was a big debate about how quickly to decontrol the U.S. economy. and there was fear that if prices were taken, price controls were removed, prices would rise. And in fact, they would rise, but the point is they'd be telling the truth about the relationship between the money supply and the amount of goods in the economy. And it would only be a one-time rise in prices, but it would be very visible.

19:09It's striking, though, that Hazard would zero in on this point about inflation, given that we just went to this long period of history where there was a hysteria about deflation, and yet, to Hazard's mind, inflation would pose the greatest danger. The other point is that in the mobilization of the economy and having more people in the labor force, that is the soldiers that were returning from Europe and the Japanese theater of war, there was a fear by mainstream economists that the economy would go into a depression, because the government was spending less on war goods and less on other things to clothe and feed the soldiers. But in fact Hazlitt knew that if the government tried to offset this recession, this imminent, what they believe is an imminent depression, with an increase of the money supply, we would have now a peacetime inflation, which would distort prices and eventually cause misallocations and recession, again.

20:04Do you think Hazlitt's explanation holds up? Yep, I think it holds up today, as well as it did in 1946. Well, very good. Thank you so much, Dr. Salerno. Thank you, Jeff, for my pleasure. The Theory of Money and Credit