A Perfect Picture Of PROFIT
Good news! Manny Mustard, my long-time friend and proprietor of Manny Mustard's House of Sandwiches is having a special on his Deluxe Club Sandwich. Let's drop in for a brief respite -- and lunch. More good news! Manny is bubbling profusely about the vitality of his business. Last month he turned a profit. Yes, that much cherished profit, the goal of business firms, be they large or small. Upon closer inspection Manny's profit calculation might be suffering from an oversight or two. It seems as though Manny neglected to pay himself a wage. Nor did he bother to include any interest expense on the savings he invested in his House of Sandwiches venture. But what the heck, he earned a profit -- didn't he?
The Many Faces of Manny's Profit
I'm afraid the Manny's jubilation will turn a bit sour once his profit calculations are refined. That's because the number on the bottom of his profit-loss statement isn't really profit. Oh, it might be profit as far as some accountants are concerned, but it won't satisfy pointy-headed economists. It's not like Manny or you should spend your lives satisfying the whims and eccentricities of pointy-headed economists -- heaven help us if we did that. But, there are a few interesting things about profit that the pointy-headed economists can tell us, like a different perspective on so-called "profits."
As if our world isn't complicated enough, there are different ways to define and calculate profit (three at last count). Each has it's own meaning and interpretation. Keep an eye out for the one favored by the pointy-headed economists. Here they are:
- Accounting profit. This is simply enough. It's the revenue a business takes in minus the expenses it pays out, and it's aptly termed accounting profit because it's what you'll get from a roomful of accountants punching numbers into their calculators. I don't mean to speak badly about accountants -- what would we do without them -- but, there are a few problems with accounting profit. In particular, when accountants follow standard accounting practices, tax codes, and the like, they're inclined to include some expenses that aren't really "cost" and ignore other "cost" altogether. The result is that accounting profit may or may not bear any relationship to a actual profit.
Before we continue, perhaps we should think about what we really mean by profit. The simplest definition is probably the best -- revenue less cost. In other words, profit is the excess of revenue over cost. The revenue in most profit calculations is pretty straightforward, however, the cost is not. For pointy-headed economists the term "cost" means opportunity cost, it means what you give up to get something. Many of the business expenses they accountants punch into their calculators are honest-to-goodness opportunity cost. A business pays out some bucks to get labor, materials, or whatever. There's no problem there. Under some circumstances, however, a business doesn't pay out accounting bucks when opportunity cost is incurred. Under other circumstances, a business pays out more than opportunity cost.
We'll pursue these thoughts further in a few paragraphs. However, at the moment, we have enough information for our second kind of profit:
- Economic profit. This is the most important profit for our economy, our society, and our efforts to efficiently use our limited resources. Specifically, economic profit is revenue minus all opportunity cost -- most that are explicit accounting expenses and others that are implicit cost with no cash changing hands. In other words, economic profit is the difference between the revenue buyers are willing to pay for stuff (which depends on the satisfaction received) and the opportunity cost of producing the stuff (which is the satisfaction that consumers don't get from stuff that's not produced).
Here's the importance of economic profit: Our economy efficiently uses our limited resources, ONLY when there's no, and I mean absolutely no, economic profit. If a business, any business, has an economic profit, then the value of the good it produces is worth more to us, consumers of the third estate, than the value of the stuff we're giving up. In other words, we want more of it than we're getting and we're willing to give up other stuff that to get it.
Sometimes You Pay, Sometimes You Don't
Before we get to our third kind of profit, let's look into some opportunity cost that is likely to differ from accounting expenses.
- Pollution. This is a good example of an opportunity cost that doesn't show up as an accounting expense, unless the government forces it on a business through taxes or regulations. The trick is that pollution tends to inflict opportunity cost on people who have nothing to do with the production, sale, or consumption of a good. A business doesn't compensate these people with a cash payment, and may not even know an opportunity cost exists. However, this unaccounted opportunity cost means that accounting profit overstates economic profit.
- Economic Rent. Of course, you're probably familiar with the term rent -- that's what you pay the landlord each month for your leased apartment. However, pointy-headed economists have a slightly different, although not totally unrelated, meaning for the term rent. Economic rent is the payment a resource owner receives over and above the opportunity cost of the resource. In other words, if you're willing to do your job for $10 an hour, but you get paid $15, then you're getting $5 an hour in economic rent. You can probably see how this might affect the calculation of profit. If resources are getting more than their opportunity cost, accounting expenses are greater than opportunity cost. The inescapable result is that accounting profit understates economic profit.
Let's not pass by this point too quickly. Market control, as we see with Fact 4, depends on the degree of competition on each side of the market. If a resource supplier has little or no competition, and thus a lot of market control, then there's a real, real, REAL good chance that the price will be greater than the opportunity cost. The supplier gets economic rent.
If further means that some of the economic profit that would have gone into the pocket of an owner goes instead into the pocket of the resource supplier. This idea of sharing-the-profit is a main objective of unionized labor. If company profit is up, then unions are out to get their share.
- Proprietor resources. A third difference between accounting expenses and opportunity cost is what transformed Manny Mustard's jubilance into despair. A proprietor, as the owner and operator of a business, is inclined to use a number of personal resources in a business with no payment and thus no accounting expenses. The reasons is pretty obvious. The proprietor, like Manny, gets to keep all revenue remaining after out-of-pocket expenses are paid. That's proprietor's income. Someone like Manny doesn't care why he gets the income, he's only concerned with how much. While he called it profit, it's really part profit (perhaps) and part payment for some of his resources. For example, as his number one employee, he uses a lot of his own unpaid labor to operate of Manny Mustard's House of Sandwiches. He also, as I alluded to at the beginning, invested some of his savings in the restaurant, without paying any explicit interest. Manny might also have overlooked payments for some natural resources that he owned, like perhaps the land where his House of Sandwiches is located. These are all cost, they're all important, and they all need to be deducted to calculate economic profit.
The Last of the Profits
We've now come to our third kind of profit. This last profit isn't really a profit so much as it's a cost -- an opportunity cost. Let me explain this potentially perplexing statement.
- Normal profit. All resources have an opportunity cost. If they're not doing one thing, they could be doing something else. This includes those risk-taking folks in our economy who organize resources into production -- entrepreneurs. Manny aptly fits the description of entrepreneur. He's taken a big risk by starting Manny Mustard's House of Sandwiches. He rented some space in the mini-mall; purchased some tables, chairs, and kitchen equipment; hired a few workers; bought the necessary sandwich-making ingredients; then started selling sandwiches. Here's the key, he could have applied these entrepreneurial efforts to another business. He could have started an ice cream parlor, convenience store, garden center, pet store, or any something else. The economic profit that he's giving up from those other alternatives is an opportunity cost -- a normal profit. In fact, it's as much an opportunity cost as the six-figure salary he gave up when he quit his job as a video game tester to "hire" himself as a sandwich maker. That six-figure wage was a payment for his labor resources, the normal profit he could have earned by organizing another business is a cost of his entrepreneurial resource.
Any business that wants to compute it's true, totally accurate, economic profit, needs to subtract a normal profit.
The Best Ways to Get Some Economic Profit
Economic profit (as opposed to accounting profit or normal profit) is the excess of revenue over opportunity cost. When it exists, our economy is inefficient. That doesn't mean it's all bad. In some cases economic profit is good. To see why, we need to see why economic profit emerges.
- Market control. The truly bad, bad, BAD economic profit arises from market control. For example, if a monopoly supplier (like Merciless Monolithic Media Masters cable television) raises the market price, then economic profit usually results. In the process, resources are inefficiently used. After years and years of long, hard study, pointy-headed economists have found nothing good to say about this source economic profit.
- Innovations. A very, very, VERY good way to get some economic profit is to introduce an innovative product or idea. If the public likes what you're doing, then you stand to accrue a small fortune, by way of economic profit. While such profit is inefficient, the innovation helps our economy expand and prosper. The short-term inefficiency of economic profit is a small price to pay for the new products that improve our long-term standard of living.
A Word on the Two Estates
Our look at profit would be incomplete without considering the second and third estates. While there is good that comes from economic profit, there's also bad.
Profit is the number one way the second estate gets a larger slice of our economy's pie. When the economic profit rolls in, the second estate becomes wealthier. When the second estate becomes wealthier, they seize more market control (and political power) and get even more economic profit. If left unchecked it could lead to (and in past societies has led to) servitude or slavery for the third estate. We're pretty fortunate in the good old U. S. of A. because we have all sorts of checks and balances that (usually) prevent this. Our democratic principles give the third estate enough political clout to keep the accumulation of wealth from tipping too far in the direction of the second estate.
This is a delicate balance in light of the good that economic profit does for our economy. How much inefficient economic profit and inequitable wealth accumulation will give us the desired economic growth and prosperity? Without profit, there's no growth. With too much profit, there's servitude.