The Origin and Meaning of Profits

The definition of profit is the excess of revenue over costs. The underlying activity that produces the revenue, and incurs the cost, can be almost anything. As Robert Nozick pointed out in his 1974 article, “Why Intellectuals Oppose Capitalism,” intellectuals find this amorphous aspecificity of the goals and reward structure of capitalism frustrating. After all, intellectuals have spent their lives going to the best schools, getting the best grades, and congratulating each other on being the most important members of society.

By comparison, entrepreneurs and business people are often uneducated, even coarse. Socially, we tend to think of Al Czervik from the movie “Caddyshack”: If you make or do something, and a bunch of people happen to like it, enough so that you can charge more than it costs to make that thing….what kind of achievement is that?

For example, do you remember the “Pet Rock” of the mid-1970s? If not, ask your (grand)parents. In 1974, a guy named Gary Dahl was in a bar, listening to some friends complain about how much work it was to keep pets. He decided that a pet rock would be a lot less work. He bought nearly a ton of ordinary gray stones at a building supply warehouse. He marketed them in cardboard boxes with air holes cut so the rock could “breathe.”

The real idea was a 32 page “owner’s manual,” with instruction on training the pet—“sit” and “stay” were basic commands, graduating to “roll over” and ultimately “attack” if the rock were thrown. The fad lasted about six months, with a burst of sales around Christmas of December 1975. More than 1.5 million Pet Rocks were sold, and Dahl was moderately wealthy.

It appears that in 2012 an updated version of the Pet Rock was offered, with a USB cable for “added functionality.” It is no longer available, as far as I can tell, but I am pretty sure that the USB port and cable didn’t actually add any functionality at all. Nonetheless, quite a few people bought them.

Did Gary Dahl produce any value for society? Does a “Pet Rock” that earns profits mean that someone should get rich? An intellectual would say, “I got straight A’s, and you didn’t even finish college, you filthy entrepreneur. We need redistribution based on social merit! Some idiot who sells rocks doesn’t deserve to wealthy!”

The Origins of Profit

This kind of question simply reverses the cause-and-effect relationship between merit and desert. (That’s “des-ERT,” or deserving a reward, not the really dry hot place). The problem with the standard view of desert is that wealth is, or should be, a reward for merit. But “social” merit is very hard to define; as Thomas Hobbes noted, in Leviathan:  “A man may be Worthy of Riches, Office, and Employment, that neverthelesse, can plead no right to have it before another; and therefore cannot be said to merit or deserve it.”

Right. But profit is not wealth awarded to people who have intrinsic social merit. Profit is the end consequence of a discovery process, a search for value that is distributed among all the many nooks and crannies of a modern economy.

Somerset Maugham wrote a famous short story, “The Verger.” Mr. Foreman has been working hard as a verger—a lay assistant to the Vicar in the Anglican Church—for more than 15 years, since he was a teenager. A new vicar is appointed, and is shocked to learn that the verger cannot read or write. The vicar demands that Mr. Foreman become literate, or leave the church’s employ.

Mr. Foreman doubts he can learn to read. He is sacked. He wanders, looking for a cigarette. But there is no tobacconist anywhere on all the long street of shops. Mr. Foreman has an idea, hardly a profound idea but an idea nonetheless, that he might open a shop. He makes substantial profits. Before long, he opens another, and then several more, in every case using the simple, in fact obvious, strategy of finding an area of the city with many shops but no tobacconist.

He amasses a fortune. Worrying about having to mind all that cash, Mr. Foreman visits a bank, where he is told by an executive that he should invest the money. Mr. Foreman declines to invest in complex financial instruments, confiding in the banker that he cannot read or write. The banker is thunderstruck, finding it remarkable that an illiterate man could acquire substantial wealth.

The banker wonders out loud, given what a success Mr. Foreman without literacy, how things might be if he could read. As Maugham puts it, “‘I can tell you that sir,’ said Mr. Foreman, a little smile on his still aristocratic features. ‘I’d be verger of St. Peter’s, Neville Square.’”

Did Mr. Foreman deserve to become wealthy? He didn’t have any merit, at least as intellectuals measure such things. All he did was to make it possible for people buy a product they wanted, at a lower price (counting travel) than had been possible before. What’s so hard, or so admirable, about that?

Mises (1952, p. 121) himself is honest about this feature of the profit and loss system.

The entrepreneurs are neither perfect nor good in any metaphysical sense. They owe their position exclusively to the fact that they are better fit for the performance of the functions incumbent upon them than other people are. They earn profit not because they are clever in performing their tasks, but because they are more clever or less clumsy than other people are. … If the grumbler knew better, why did he not himself fill the gap and seize the opportunity to earn profits? It is easy indeed to display foresight after the event. In retrospect all fools become wise.

Israel Kirzner, a student of Mises, gives a classic description of the relation between profit, value, and entrepreneurship: correcting errors.

Let us consider the theorem which Jevons correctly called “a general law of the utmost importance in economics,” which asserts that “in the same open market, at any one moment, there cannot be two prices for the same kind of article.” …Now the existence of such a tendency [toward a single price] requires some explanation. If the imperfection of knowledge (responsible for the initial multiplicity of prices) reflected the lack of some “resource” (as where means of communication are absent between different parts of a market), then it is difficult, without additional justification, to see how we can postulate universally a process of spontaneous discovery…

We understand, that is, that the initial imperfection in knowledge is to be attributed, not to lack of some needed resource, but to fail to notice opportunities ready at hand. The multiplicity of prices represented opportunities for pure entrepreneurial profit; that such multiplicity existed, means that many market participants (those who sold at the lower prices and those who bought at the higher prices) simply overlooked these opportunities.

Since these opportunities were left unexploited, not because of unavailable needed resources, but because they were simply not noticed, we understand that, as time passes, the lure of available pure profits can be counted upon to alert at least some market participants to the existence of these opportunities. (Kirzner, 1978; emphasis added)

Kirzner defined entrepreneurship as “awareness,” the constant searching for profit opportunities. But Kirzner conceived of errors much more broadly than the above passage would suggest. Rather than simply “correcting” errors in the price system, and causing the convergence of prices of a single existing commodity, entrepreneurs imagine alternative futures, new products, and possible ways of organizing production.

It is difficult to overstate the importance of this distinction. An entrepreneur does not (just) take advantage of errors (i.e., differences) in prices. An entrepreneur cultivates a character of alertness, looking to anticipate what consumers want. But that means that the system is ultimately driven (though perhaps passively) by consumers, not entrepreneurs. Entrepreneurs are the active agents in the system, but consumers decide what firms produce and which productive activities will be rewarded and which punished.

 The verger, Mr. Foreman, corrected an error in the system. There should have been a tobacconist there, in that spot. No one else recognized that, but the absence of a tobacconist was a mistake. Consumers wanted a store there (though even consumers may not have recognized this fact!).

That’s what I mean about being confused about the direction of causation: one doesn’t have merit, and then receive rewards. The entrepreneur seeking profits creates something new, correcting a mistake. If the costs of correcting the mistake are less than the benefits in terms of (as I discussed earlier) the consumer surplus created, the result is profits.

There is no particular reason to expect that education or intellectual interests are an advantage in cultivating a habit of awareness of the sort Kirzner highlights. But there are very good reasons to argue that profits, deserved or not, are something that entrepreneurs should be legally entitled to seek.

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Michael Munger

Michael Munger is Professor of Economics at Duke University and Senior Fellow of the American Institute for Economic Research. His degrees are from Davidson College, Washingon University in St. Louis, and Washington University.