September 24, 2015

Profits, Entrepreneurs, and the Social Welfare: What is Profit I

By In Blogs, Brian Jacobson

(see part 1 of this series here)

What is Profit?

One fundamental point of both Ludwig von Mises and Murray Rothbard is that profits are not a normal or natural phenomenon. They exist only in a world of uncertainty and disequilibrium. In the evenly rotating economy, the conception of which was a unique contribution of Mises’s, there are no profits. The evenly rotating economy was a dynamic conception of the hypothetical equilibrium state within an economy  in the value of all inputs match the revenue of all outputs(where supply always equals demand, the interest rate equals people’s time preference, etc.). It’s an imaginary construction of an economy in a perfect state of rest that could still grow. Of course such a thing does not exist because in the real world there is uncertainty. Future prices are not known, consumer demand is merely guessed, and quite simply humans err. Raw materials and laborers do not come with price tags but their valued is estimated and agreed upon by buyer and seller, who of course may be wrong.

What Entrepreneurship is NOT

Let’s begin with a couple things that entrepreneurial activity and profit is not. Entrepreneurial profit is differentiated from other incomes or profits for a couple reasons (noted in part I of this series).The returns of interest, rent, and wages are level, permanent, and relatively risk free as opposed to the profits of entrepreneurs which come about only from maladjustments of the factors of production and of which profits are themselves the eliminators of. Thus profits and high profit industries are always shifting, what was profitable ten years ago is not always profitable today. Profits are a perpetual phenomenon only because capitalist-entrepreneurs perpetually adjust and anticipate market values and maladjustments.

Secondly, entrepreneurial profit is not simply technological improvement and innovation. While many entrepreneurs have become famous through their use of technology and pushing out new technology to the public they are not themselves the inventors but always the arrangers of currently existing technology into economically feasible production processes to create a good consumers actually demand at a price they can afford. As Rothbard explains “to expand production, the important consideration is not so much technological improvement as greater capital investment. At no time has invested capital exhausted the best technological opportunities available. Many firms still use old, unimproved processes and techniques simply because they do not have the capital to invest in new ones. They would know how to improve their plant if capital were available. Thus, while the state of technology is ultimately a very important consideration, at no given time does it play a direct role, since the narrower limit on production is always the supply of capital.”[1] Technological advancement and development is not synonymous with entrepreneurial activity nor does it automatically accompany profit. In fact incorporation of presently advanced technology for a given part of a production process is as likely to be an entrepreneurial mistake and cause losses as it to bring profits. Much technology is too expensive relative the added value it gives to a product or efficiency it provides in the production process. Entrepreneurial activity involves ordering the production process and incorporating those technologies which are most economical given the final price of the product (discounted marginal value of the product).

Profit again is not a normal or given phenomenon. Capital does not “beget” profit, as Marx thought and as Picketty seems to imply of late. You may need to have money to make to money but having money by no means makes you money. As Mises pointed out “the capital goods as such are dead things that in themselves do not accomplish anything. If they are utilized according to a good idea, profit results. If they are utilized according to a mistaken idea, no profit or losses result. Profit is not a rate that automatically accrues to the businessman once he has completed the steps of x,y, and z.”[2] Similarly as he said elsewhere “The various complementary factors of production cannot come together spontaneously. They need to be combined by the purposive efforts of men aiming at certain ends and motivated by the urge to improve their state of satisfaction.”[3] Entrepreneurs are those who judge future consumer demand and arrange present factors of production accordingly.

Profit: Fixing Maladjustment

Profits happen when there is a discrepancy between the factors of production and the revenue of the final good. “The valuation of factors of production,” according to Rothbard “is derived from actors’ evaluation of their products (lower stages), all of which eventually derive their valuation from the end result—the consumers’ good.”[4] That is to say factors of production are valued, or priced, solely based on their anticipated value of the good it will produce (since factors are not consumed themselves or for their own sake otherwise they are consumer goods not capital goods). In economic terms the price of the factors is imputed backwards through the production process from the discounted marginal value product (total revenue of a product unit minus the going interest rate)But, if the sellers of factor either a) doesn’t properly evaluate the use factor X has for the goods it produces or b) doesn’t realize the possible goods it could produce then the factor will be underpriced and will present a profit opportunity. Thus profit exists when there is a maladjustment between the factors of production the value of the final good, when the factors have been underpriced and undercapitalized.[5] Profits only occur in a state of disequilibrium when there is a previous maladjustment between production and production as it should according to available material and their true worth (supply and demand). This however is only the state in which profits can occur, an entrepreneur must recognize, expect, and act upon his judgment of a potential profit. As Robert Murphy explains “in the classic formula, the entrepreneur wants to buy low and sell high. This is possible only if the entrepreneur realizes that today’s resources can be deployed in a particular outlet that has been overlooked.”[6]

The entrepreneur is one who best sees through the uncertainty and anticipates consumer demand and changes in factor pricing. “What makes profit emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market are too low. Thus the total costs of production—including interest on the capital invested—lag behind the prices which the entrepreneur receives for the product. This difference is entrepreneurial profit.”[7] It was this that led von Mises to conclude that profits have their origin in the mind. It is in the mental acts of entrepreneurs that they ultimately originate. “Profit is a product of the mind, of success in anticipating the future state of the market.” Mises goes so far as to say that “It is a spiritual and intellectual phenomenon.”[8]

Entrepreneurial activity is itself the remedy to a previous maladjustment and profits are the prize awarded to those who remove this maladjustment. The greater the preceding maladjustments, the greater the profit earned by their removal. Thus not only are profits not normal but also successful entrepreneurship always works toward the reduction and ultimately the eventual elimination of profits as the factors of production and prices of goods equalize. Capitalist-entrepreneurs purchasing of the factor has the effect of bidding up the price to its equilibrium level. “Any realized profit tends to disappear because of the entrepreneurial actions it generates.”[9] Rothbard argues that by acting upon a maladjustment and gaining the profit, he calls everyone’s attention to that maladjustment and sets forces into motion that eventually eliminate it. The very entrance of yet another entrepreneur into the field puts downward pressure on the prices of the goods at the very time that the factors are being bid up by increased demand by the entrepreneurs thus shrinking the rate of return. As pointed out by Böhm-Bawerk, an early Austrian, costs conform to prices, and not vice versa.

Too high of profits are a non-problem. They are simply a momentary phenomenon the very existence of which presents a signpost for entrepreneurs to enter that market thus eliminating whatever profits were previously there. The high profit is itself the incentive with which the profits can be diminished by increased entrance and activity in said market. The best thing to do about “too high” of profits is to enter that market for yourself not to reduce the incentive for any entrepreneurs to enter it. This would only exacerbate the clear shortage of activity in that field demanded by consumers. Profits are the result of the lack of resources in an area that consumers demand. As Mises stated “profit and loss are generated by success or failure in adjusting the course of production activities to the most urgent [read valuable] demand of the consumers. Once this adjustment is achieved, they disappear. The prices of the complementary factors of production reach a height at which total costs of production coincide with the price of the product.”[10] There is always a movement in the economy of capital from low profit areas to high profit, the best entrepreneurs are always one step ahead of the bunch.  

Not only does this but entrepreneurial activity towards undervalued factors shrink the rate of return but it is also opens the gap in other areas for more entrepreneurial activity.  That is to say simply because there is undervaluing of factors in one area which is subsequently solved by entrepreneurs does not mean that the factors in the previous area remain unchanged. Robert Murphy explains “by fleeing from unprofitable lines, the supply of the final product is reduced (raising its price) while the demand for the relevant factors is reduced (lowering their prices); the net result is a rise in the rate of return.”[11] In addition to bidding up undervalued profits entrepreneurs also reduce the price of overvalued factors thus making their use more profitable. With profits some is consumed while the rest saved and becomes capital to be used for more profits. “The increase of capital available creates maladjustments insofar as it brings about a discrepancy between the actual state of production and that state which the additional capital makes possible.”[12] Thus creating more opportunities for profits .This is the only reason profits remain perpetual, because there is perpetual change and adjustment (and thus maladjustment) happening in the world. All values and prices in these areas, and their future prices, are estimated, and thus there is always the possibility of erroneous estimates. “Profit and loss are ever-present features only on account of the fact that ceaseless change in the economic data makes again and again new discrepancies, and consequently the need for new adjustments originates.”[13]

[1] Murray Rothbard, Man, Economy, and State with Power and Market, 626.

[2] Ludwig von Mises, Profit and Loss, 20.

[3] Ludwig von Mises, Human Action, 249.

[4] Murray Rothbard, Man, Economy, and State with Power and Markets¸ 12.

[5] Ibid, 510.

[6] Robert Murphy, Choice: Cooperation, Enterprise, and Human Action, 140.

[7] Ludwig von Mises, Profit and Loss, 7.

[8] Ibid, 20.

[9] Murray Rothbard, Man, Economy, and State with Power and Market, 511.

[10] Ludwig von Mises, Profit and Loss, 8.

[11] Robert Murphy, Study Guide to Man, Economy, and State with Power and Market, 97.

[12] Ludwig von Mises, Profit and Loss, 24.

[13] Ibid, 8.

Written by Brian Jacobson

Brian Jacobson works as a quality technician for a manufacturing company in St. Louis, Mo where he lives with his new bride. He studied biblical and theological studies at Reformation Bible College under R.C. Sproul in Orlando, FL. He’s an Old-School Presbyterian who enjoys the simple means of grace, Machen, and living the high life on a budget. Follow him @briankjacobson on Twitter.