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What Drives Profits?

Mises Daily: Thursday, November 18, 2010 by

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The economic and business community constantly attempts to forecast the effects of various economic changes and government policies on corporate profits. But both the cause and effect of increasing profits are other than what most people imagine. It will therefore be helpful to gain a concrete understanding of what profits do and do not represent.[1]

What Are Profits?

First, it is necessary to understand exactly what profits are. Profits, narrowly defined, are the excess earnings that companies make from forecasting economic changes accurately at the expense of other companies that forecast incorrectly. As Mises said, "If all people were to anticipate correctly the future state of the market, the entrepreneurs would neither earn any profits nor suffer any losses."

But to understand profits in the wider sense is to understand how it is that total economy-wide business revenues can exceed total economy-wide business costs, year in and year out (Revenues − Costs = Profits). Total economy-wide revenues consist of (1) spending by companies to purchase capital goods from capital-goods-producing companies, and (2) spending by individuals to purchase consumer goods from consumer-goods-producing companies. The two together comprise all the sales revenues received by all companies in the economy.

The spending by the purchasing companies reflects their spending for capital goods (supplies, materials, tools, machines, etc.) on their income statements and budgets. An example would be Boeing purchasing aluminum alloys from Alcoa.

The spending by consumers is derived from — and reflects — the spending for wage payments by businesses: workers receive wage payments and spend their money on consumer goods. An example would be a Boeing factory worker purchasing movie tickets from Regal Cinemas.

Thus, businesses engage in two basic forms of spending: purchases of capital goods and purchases of labor.

Since the money businesses receive originates in one form or another from the spending by businesses themselves, one would think that the total economy-wide spending that businesses engage in (economy-wide business costs) would be equal to the total amount businesses receive (economy-wide revenues). In this circular flow of spending, one would think that costs would equal revenues, therefore leaving no aggregate profit.

Costs in fact do equal revenues. But in addition to business and consumer spending on capital goods and consumers' goods (the two types of spending for companies' products that constitute sales revenues), there is yet another form of spending that does not have any corresponding prior costs. This is the spending by individual investors and businessmen from dividends, draw, or any other form of disinvestment in a company.

When funds invested in companies are withdrawn and are instead consumed to purchase consumer goods or services, there results economy-wide spending over and above the spending that comes from the spending on capital and wage payments; this spending generates sales revenues without corresponding costs, since dividends, draw, and the like are not regular company expenses in the form of income-statement items. While draw and other distributions are somewhat random, various companies are always paying out regular dividends that are consumed and not reinvested. The spending of these monies causes sales revenues to be greater than costs.[2] Similarly, money taken from under the mattress and spent on consumer goods would also help sales revenues to be higher than costs.

In this broader view of profits, time preference and the corresponding savings rate affect the rate of profit by affecting the rate at which people disinvest and consume their capital.[3] The higher people's time preference, the faster they will consume their invested funds and the higher will be the rate of profit.

This line of reasoning is aligned with the traditional view of time preference and savings: the fewer savings available, the higher the rate of interest. (It must be remembered that interest exists only because profit exists.)

The explanation above describes what constitutes real profits — profits in the economy prior to the effects of money and credit.

But money and credit do in fact have a tremendous affect on nominal profits: as the money supply is increased, profits increase because revenues rise faster than costs. Various accounting techniques such as costs of goods sold and depreciation cause many costs on companies' income statements to be recognized in a delayed fashion. At any given time, then, income-statement costs largely reflect productive expenditures made years prior, while the corresponding revenues reflect current sales values.

Given that much of the cost of production was incurred in the past, and given the ever increasing quantity of money through time, the monetary value of revenues is usually greater than the monetary value of corresponding costs, since most costs were incurred when there was less money existing (i.e., when things cost less and therefore had a lower monetary value). Thus, because of inflation, the total monetary value of business costs incurred in a given time frame is smaller than the total monetary value of the corresponding business-sales revenues. Thus, credit expansion increases the spread between revenues and costs, thereby increasing profit margins.

The higher the rate of inflation, the wider are profit margins. This is why companies in countries with very high inflation have high profit margins (and high interest rates).[4]

With these two drivers of profits in mind — disinvestment spending and credit creation/inflation — let's take a look at the various economic and policy drivers that might or might not affect economy-wide aggregate profits.

Technology and Productivity

Technology and productivity are widely cited as drivers of increasing profits. The general argument is that because these things help bring about increased economic growth, companies are able to produce more goods and make more money, thus increasing their profits. But as I have explained previously, economic growth does not consist of companies making more money, since companies do not actually create money (the central bank does); it consists of their making more goods and services.

Technology and productivity can help some firms make higher profits at the expense of other firms: think about the first jet-airplane manufacturer taking business away from manufacturers of prop engines, or owners of the first electric sewing machines taking business away from those who sewed by hand.

But one firm's gain is another's loss. And if all firms adopted a new technology or a productivity-enhancing tool, there would be no source of excess profits. Taking all firms together, technology and productivity serve to increase the rate of production but they do not increase economy-wide profits.

Central-Bank Policies

Since the central bank is the entity responsible for enabling the banks to extend more credit and expand the money supply and therefore the volume of spending (velocity), it is an important driver of corporate profits. Because company revenues rise faster than their largely fixed (partial-historical) costs, when the central bank prints money and raises prices, profits are expanded. By contrast, when the money supply and volume of spending contract, revenues fall more quickly than costs, resulting in rapidly shrinking profit margins.

We have seen both of these effects in action during the last few years. Starting in 2007, due to mortgage-related losses, the volume of spending in the economy declined significantly. Thus, business revenues fell accordingly, resulting in compressed corporate earnings.

Then, the Fed came along in 2008 and more than doubled the monetary base; the portion of those new reserves that were loaned out by banks were taken by businesses and spent to buy goods from other businesses, causing a surge in business spending. This spending once again raised revenues and earnings much higher than costs; it raised profit margins.

It is this spending of new credit — not true consumer- and time-preference-driven economic growth — that is currently causing companies to be more profitable. True economic growth would result not in increased (monetary) revenues and profits but instead in steady ones and falling prices, as explained in this article.

The Degree of Capitalism

Counter to expectations, the more capitalism, the lower, not higher, are the profits. Capitalism, in this context, refers to the degree of business investment in the economy. It can also be regarded as the proportion of spending in the economy devoted to production versus consumption.

To fully grasp this inverse relationship between profits and the degree of capitalism, we must understand that the original and most basic form of income is profit, not wages.

A quick example will illustrate this concept. Suppose you rent a retail space in which to sell hot dogs. You also purchase machinery and supplies and hire workers to help sell hot dogs on a daily basis. Assume that in the first year you make $100,000 in sales and have to deduct $70,000 worth of costs: $20,000 in supplies and $50,000 in labor (for simplicity, we'll assume that rent is a "supply"). This leaves a net profit of 30 percent ($100K − $70K = $30K; $30K / $100K = 30 percent).

The profit exists after paying wages. Had there been no wages, the profit would have been much higher at 80 percent ($100K − $20K of supplies / $100K). Contrary to the Smithian/Marxian view, wages are deducted from profit, not vice versa.

Had there been a greater investment in supplies and labor, say $90,000 instead of $70,000, profits would have been only 10 percent instead of 30 percent. The greater the amount of business investment (i.e., productive spending and degree of capitalism) in the economy, the lower is the rate of profit.[5] Conversely, the lower the business investment is, the greater the rate of profit.

It is not true, however, that any individual business can prosper by spending less on production in order to raise its profits — it would be rapidly wiped out due to a lack of both capital and monetary income.

Taxes and Government Spending

The greater the proportion of government spending in the economy, the higher the rate of economy-wide profit is. To the extent that the government imposes taxes (the main source of government spending) that are paid with funds that would otherwise have been spent on investments of labor and capital (business investment), the effect is to raise the pretax rate of profit.

This is because money that businesses spend to pay taxes is taken away from business spending. Suppose our hot-dog business above has to pay $10,000 in taxes when its business spending is $90,000 and its corresponding profit is 10 percent. In order to maintain its after-tax profit of 10 percent it will have to pay taxes out of what it would have otherwise spent on capital and labor. Its previous pretax profits of 10 percent are now increased to 20 percent: $100K − ($90K [investment spending] − $10K [to pay taxes]) = $20K; $20K / $100K = 20 percent. Conversely, if the company were then given a tax break, it would invest the savings on capital and labor.[6]

At the aggregate level, businesses as a whole, when paying higher taxes, divert spending from productive processes to taxes. Businesses spend less in the economy, but government takes up that slack by spending more. Thus, spending on production is replaced with spending on consumption. Total economy-wide revenues, therefore, stay the same, but corresponding business costs decrease since business spending is lower than before. With the same total revenues but lower costs, the economy-wide rate of profit is higher.

The consequence of this higher rate of profit is a reduction in standards of living. With businesses investing less in productive processes, fewer goods and services are produced, and consumer prices rise relative to wages.

Paradoxical as it might sound, lower profits and lower prices — not higher profits and higher prices — are what result from economic progress. All taxes applied to profits, interest, inheritance, etc. — taxes paid with funds that would otherwise support productive processes — reduce economic growth.

Conclusion

These explanations of the forces affecting profit are not in any way intended to denounce profits — quite the opposite.

For it is the seeking of profits that is the key to increased living standards for everyone. But it must be understood that high profits do not necessarily correspond to real economic growth and can come about due to adverse circumstances. More importantly we must grasp that neither the existence of high profits nor the goal of raising the rate of profit of all companies are necessarily economically beneficial.

Notes

[1] Most of the insights in this paper consist of summaries of principles originally laid out by professor George Reisman in his book Capitalism: A Treatise on Economics.

[2] This excess spending, which causes sales revenues to be greater than costs, is what Reisman has termed net consumption.

[3] To reconcile this view with the traditional Austrian explanation of profit and interest, please see George Reisman's 2005 Mises University lecture on profit and interest.

[4] Since it is profits that pay interest, high interest rates can exist only if high profits exist. If profits were lower than interest rates, businesses could not afford to pay the interest, and rates would fall to the level of profit rates.

[5] It should be remembered that the economy-wide rate of profit is necessarily unrelated to the overall profitability of individual firms and to the real standards of living of individuals. The explanation, however, is beyond the scope of this article.

[6] Due to competitive market forces and the company's own need for a higher amount of profit — i.e., because it could make more on higher volume carrying a lower percentage profit — the company would not keep the difference as profit. For a better understanding, please see discussions in my book The Case for Legalizing Capitalism on the uniformity-of-profit principle (pp. 40–41) and competition for labor services (pp. 51–52).