AS THE ECONOMY TURNS
PROFIT IS NOT A DIRTY WORD
Dr. William Shingleton
One of the advantages to teaching at the university level
is that students often provide me with information that I would not have come
up with on my own. Not just about I-Pods and I-passes, but about
perspectives. For instance, I had been
happily distributing AS THE ECONOMY TURNS for years until one of my students
informed me that I needed to mail everything out under the bcc: designation
because there are some idiots out there who collect lists of viable e-mail
addresses and sell them. I never knew. However, sometimes what students know, or at
least think they know, is a little scary.
Then I worry, because if these future leaders of our society are so
ill-informed about real life, what is the quality of information that the
general public takes for granted?
Consider the role and volume of profits in the American economy. Off the top of your head now, try to deal
with a recent question on one of my examinations from an introductory course. Out of each dollar volume of sales in the
economy, about how much is accounted for by profit? More than 50 cents? About 25 cents? Between
10 and 15 cents? Almost nothing?
The dollars and cents facts are that corporate profits in
the second quarter of 2005 were $1,348 Billion in an economy of $12,378
Billion, which works out to about 10.9 cents on each dollar of sales. [SOURCE:
Table 9 in <http://www.bea.gov/bea/newsrel/gdpnewsrelease.htm>]
And, in case you had not noticed, the 10.9
cents was actually a big jump from last year’s 9.9 cents. Needless to say, we would not be writing this
particular newsletter if more people had a better idea of what was actually going
on. Just consider this, the cost of replacing worn out plant and equipment
($1,457 B) was greater than the total volume of corporate profit in the
The first kind of profit is what economists refer to as a NORMAL
PROFIT, the minimum profit necessary to keep a business in action. Although I’ve never seen a good dollars and
cents estimate of how much of our total profit is normal profit, we know that normal
profit is the glue that holds the economy together, the stuff that keeps firms
operating so that they can provide us with goods, services, jobs, and incomes. A business, after all, is an organization, a
combination of resources [Economists call the resources FACTORS OF
PRODUCTION.], such as workers and equipment.
For a business to function, somebody needs to be willing to take the
risks (and often trouble) associated with owning it. (Of course, we could let the government run
things, but that’s how we ended up with FEMA, so we doubt that anybody wants to
push that envelope too far.) The role of
the normal profit is to make a business attractive enough to somebody so that
they want to own it and to make the products profitable enough so that the
owners of the business want to produce them.
Interestingly enough, (O.K. interesting enough to an
economist!) economists count normal profits as part of the costs of doing
business. After all, ownership is itself
a factor of production, just as much as labor, since a firm without ownership
would be a firm that could not produce anything, because it would not exist. And
if a business is not profitable enough to make it worthwhile to some owner it
will cease to exist, perhaps by going bankrupt.
Then it will stop producing goods and/or services, and it will stop
providing either jobs or incomes. Since
we have thousands of businesses in the
The second kind of profit is what we call ECONOMIC PROFIT,
that’s the type of profit that provides the dynamic drive to the economy and is
defined as the profit that a firm can expect to make over and above the normal
profit. A great example is APPLE
COMPUTER with its I-PODS. A few years
ago, Apple was struggling along in the PC market, producing a good product but
not lighting any fires on Wall Street.
They kept going because they expected to be able to earn enough profit
in the PC market for it to be worthwhile.
APPLE then developed the I-POD which was a market smashing hit. [When a company is smart enough to go off in
a different direction like this, producing a new product for a new market, it
has an advantage from its ECONOMIES OF SCOPE, using its pre-existing production
and marketing base to expand its product line.]
The economic profits that APPLE has generated in this market are now
attracting other companies, such as SONY and MICROSOFT, who want a piece of the
action. In our economy, when an industry
shows economic profits, profits that are above the normal, other firms usually
come rushing in to compete, increasing the supply, and driving the price
down. Eventually, there is usually so
much competition from the new firms that the economic profits melt away. The
lesson, as we have noted in an earlier newsletter, is that the profits belong
to the firms who are smart enough to be first or at least quick enough to be
next in line.
While the normal profits keep our firms operating, it is the
prospect of future economic profits that keeps attracting firms to the latest
opportunities. But note that it is the
PROSPECT of economic profits that drives the system. When a firm makes a decision to go into a new
market or to try a new process it often does not know how everything is going
to turn out; there is an element of RISK involved. We get to see the huge profits that a
corporation like EXXON earns from an oil rig but it’s easy to forget that when
the hole was first put into the ground nobody really knew whether or not there
was any oil there. The failed rigs and
the failed companies (including a couple run by a guy named George Bush) litter
the industry. Those companies took the
risk and lost. For the industry to be
profitable enough to continue, the profits on the
successful ventures have to be high enough in good times to cover the losses
that the companies suffer when the market is down or the wells are dry.
It’s less dramatic for a local restaurant or hardware
store. When the company starts out the
owners certainly believe there will be profits there. But it’s only after some time, after some
money and effort have already been invested, that the owners find out whether
or not they can even earn the normal profit.
And if the profits get too high, the economic profits then attract the
competition that benefits consumers but drives the profits back down to the
normal level. In any case, the biggest profits go to the
companies that can keep their sales growing and their costs down, and Wall
Street places the highest value on the firms with the best prospect for future
profits. In simple terms, the value of a firm is determined by its expected
profits and its profits, in turn, are the difference between its sales and its
costs. Logically, problems can arise
when either the sales stop rising or the costs start going up, which brings us
to the present period, in which we are starting to get some signs of fading
consumer confidence at the same time firms are facing rising energy costs.
Firms are currently trying to deal with the same higher
energy prices we all face. They have a number of possibilities. The most
obvious adjustment is to try to pass on the higher costs to their customers by
raising prices. However, if a firm was maximizing
its profits before the cost increase and the cost increase causes it to change
its behavior, then it’s going to end up with lower profits because there is
only one profit maximizing pattern of behavior.
Trying to raise my prices to pass along the cost of higher energy will
almost always lead to my customers buying less. [Technically, the higher price
I charge causes a reduction in the QUANTITY DEMANDED I get from my
customers.] If my customers are going to
buy less then the logical plan for me would be to produce less because I don’t
want to get stuck with too much in unsold inventories.
The reduction in output, in turn, affects the number of
workers that I need. I need to cut back
on hours or lay some people off whenever I cut back on my production. This change in my labor use is called an
OUTPUT EFFECT. (If I increase my output
at some point in the future the output effect would work the other way, I would
hire more people or employ them more hours.)
What a lot of people don’t realize however is that there will be a
second effect in the labor market, one that will counterbalance at least some
of the labor cutbacks associated with the output effect.
For some companies there are different ways to get a job
done and a product produced and sold.
Like we said earlier, firms are always trying to get their costs down as
low as possible, so they search for the least expensive ways to do things. This is called COST MINIMIZATION. However, a major change in the price of a
resource such as energy would cause a well-managed firm to re-evaluate its
options. While the choices won’t change
for all firms, for many firms a higher energy price means that it will become
less expensive to use a little less energy and a little more labor. This type of adjustment is known as a
SUBSTITUTION EFFECT and will cause some firms to use more labor and less energy
to produce a specific volume of output. Since
the substitution effect says that firms will use more labor and the output
effect says that they will use less, we should expect to see some firms
expanding their labor use at the same time other firms are cutting back. The bottom line is that we aren’t completely
sure what will happen to the number of jobs if the high energy prices continue,
although it’s hard to imagine that the number of jobs would increase.
There is a related set of numbers that will be coming out
about the current period that will be misleading. Those are the numbers for LABOR PRODUCTIVITY,
output per hour of labor [The technical label is the AVERAGE PRODUCT OF LABOR.]. Think back to the substitution effect. If I am producing 1200 units of output using ten
hours of labor and two million kilowatts of energy then my productivity is 1200
divided by ten hours of labor or 120 units per labor hour. After the increase in energy prices I might add
two hours of labor in order to save a thousand kilowatts. The Labor Department is going to report that my
productivity has dropped to 1200 divided by 12 or 100 units per labor
hour. I was smart and reduced my energy
use but the Labor Department only reports LABOR Productivity, not energy
efficiency. Just remember, firms are
not in business to maximize Labor Productivity or Energy Efficiency, to put it
technically, they are in business to make a buck. In the long run, everything they do is to
achieve that end. It’s the
Final
notes: If you would like to be removed
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<http://www.oocities.org/wsirius30/2cents.html>. The opinions expressed
in these newsletters are those of the author.
Comments, including suggestions for future newsletters, are always
welcome.