– September 2, 2020

“Profit and Loss” is the title of a booklet by Ludwig von Mises. It’s a good place to start exploring the works of the fountainhead of modern Austrian economics if you’re new to the subject. Read this one-hour piece and some of his other shorter, simpler works before diving into his magnum opus, Human Action.

Alas, profit remains a dirty word in the thinking, or perhaps mindless emoting, of too many people. This was brought to the fore recently when Joe Biden called for “an end to the era of shareholder capitalism.” It’s not clear whether he was pandering to his left wing or whether he really believes this. But one thing is sure: as a politician Joe Biden has never had to grapple with the reality of trying to earn a profit in a competitive market.

Before getting into profit and loss I would like to share a quick personal story. I co-founded a startup engineering firm many years ago. I remember vividly the first couple of years when it wasn’t at all clear whether we would pull out of the dive we were in—losing money—and emerge into the black. More than anything, I was terrified of disappointing our investors. Even later, as we succeeded, grew, and prospered modestly, we continually felt the burden of meeting payroll, paying expenses, and hoping something would be left over for our patient shareholders. They had risked their hard-earned savings with us, taken the chance of suffering losses, and deserved to share the profits.

To an accountant, profit is simply the excess of income over expenses in a given time period. But sometimes expenses exceed income, so profit is negative—a loss. Hence the title of the Mises booklet. Discussions about profit should always include loss either explicitly or in the background. Loss is often forgotten because firms that lose money for extended periods have to cease operating and drop out of sight. The remaining firms are generally profitable; those that have lost a lot of money are largely gone and forgotten. (Check out Bastiat, “What is Seen and Unseen.”)

Profit and loss are residual amounts and can be quite volatile. If you take in $1,000 and spend $900 you have a $100 profit. That sounds good, but if your gross income fell by just 5%, to $950, your profit would be cut in half. You could be headed for losses.

Economists take a different view of profit. They focus on the amount by which accounting profits, if any, exceed the market rate of risk-free interest, calling this excess “economic profit.” Firms that enjoy economic profit face competition that tends to undercut their prices and drive their accounting profits down toward the risk-free rate of interest. In other words, economic profit is transitory in a competitive market and is driven toward zero.

The wider significance of profit and loss was spelled out by Mises. Profits and losses are the means by which we consumers direct the uses of scarce capital and labor. Through our buying and abstention from buying, we make certain activities profitable and others unprofitable. I feel good about buying from profitable firms in competitive markets such as Safeway, CVS and Wells Fargo (for retail banking service). They know very well they have to please us customers if they’re going to deliver for their shareholders as they usually do. They’re nice to me and I’m happy with the goodies I get from them.

The foregoing discussion has been predicated on the existence of competitive markets, but those markets have become more and more distorted by government regulations. Even without Biden’s threat to break the back of shareholder capitalism, firms have increasingly had to pivot from pleasing their customers toward pleasing bureaucrats and politicians. More precisely, they have to defer to their high-paid corporate lawyers who convey irresistible political pressures.

Many firms don’t just react to government intervention but seek it out. They vie for cushy government contracts. They lobby for special privileges like tariffs or regulations that are particularly hard on their smaller competitors.

Back to Joe Biden. Businesses “have a responsibility to their workers, their community, their country.” It’s untrue, he says, that a company’s primary responsibility is to generate returns for shareholders. But in fact, shareholder returns are aligned with Biden’s feel-good truisms. In competitive markets, kindness and thoughtfulness extended to workers, customers, and suppliers are all ways conducive to long-term shareholder returns. Likewise environmental stewardship. Joe Biden likely never heard of Adam Smith, who taught that the invisible hand of markets drives even the greediest business person who, pursuing only his own interest, “frequently promotes [interests] of the society more effectually than when he really intends to promote it.” Anyway, most business owners are not driven mainly by short-term greed. I for one am proud of the family spirit we engendered in our little business as reflected in the low turnover of our engineering staff.

Of course some firms, generally thought of as “capitalist,” do not really compete for their accounting profits. Lockheed Martin (LMT) is an example. It gets 71% of its income from the U.S. government and probably a similar share of its profits. Though it does compete with other aerospace firms for government contracts, LMT need not worry about consumer demand as their long-gone commercial aircraft operation once did. The taxpayers who fund LMT were not consulted, except very indirectly through their representatives in Congress. But LMT’s stock has done quite well, thank you very much, its per-share earnings having doubled in the last five years. Yet conflating its profits with those of Safeway or CVS is very misleading.

Sound bites may be good for political harangues but they are never enough for true understanding. Dissing profits is misleading if no distinction is made between consumer-driven competitive profits and crony-capitalist ones, or if losses are overlooked. Unqualified praise of profits can be misleading as well. We live in a mixed economy so things are complicated; there is no substitute for thinking and researching carefully about economic concepts.

Warren C. Gibson

Warren Gibson

Warren Gibson is retired from two careers: as an engineer and a lecturer in economics at San Jose State University.

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