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Profits and Losses
Daniel Davies thinks that it's a point in favor of heterodox economics that neoclassical economics assumes profits are zero ("normal") while profits in the real world are not zero. Tyler says the explanation is market power. I think both are mostly wrong.
Take a look at the national income accounts. Most of gross domestic income is wages, about 56%. Proprietor's income and corporate profits are together about 17% but most of proprietor's income is really labor income and a good chunk of corporate profits is interest and a return to capital. In a generous accounting true profits might be 5-10% of gross domestic income - not zero but not very large either. Indeed, 5-10% is an amazingly low figure when one recognizes that the entire capitalist economy depends on the existence of profits.
Is the explanation for profits monopoly power? Not really. Or rather, the better way of phrasing it is that most profits are a return to innovation and entrepreneurship. Innovation and entrepreneurship typically bring some market power but disequilibrium monopoly has very different implications for policy than equilibrium monopoly.
Here's some intuition. Textbook neoclassical economics says profits and losses are zero. The standard monopoly story can explain profits but not losses. The return to entrepreneurship/dynamic economy/creative destruction story that I am telling can explain both profits and losses.
Thus Davies is correct, profits do suggest a role for heterodox economics but it's not the paleo-Keynesian/Marxist heterodoxy that gets the boost but the Austrian heterodoxy of Mises, Hayek and Schumpeter.
Posted by Alex Tabarrok on June 8, 2007 at 07:11 AM in Economics | Permalink
Comments
I don't think your view is so far from mine...I view some of the distinctions in your paragraph three as semantic. It is true that equilibrium vs. disequilibrium theories have different implications for *policy*, but in terms of where profits come from I think it is still fine to say "market power," admittedly often from entrepreneurial sources.
Posted by: Tyler Cowen at Jun 8, 2007 7:49:26 AM
Market power: maybe the creation, application, and maintenance of process?
Posted by: Al Abbott at Jun 8, 2007 8:57:05 AM
Wait a minute. No one assumes or believes profits are zero. What economics teaches or believes is that no one earns superior returns.
for example, the long run or trend growth rate of S&P 500 earnings per share is 7%. That is the basic rate of return that Davies is calling zero.
What theory says is that overall earnings will not exceed this fundamental rate of return, not that there are no profits.
Posted by: spencer at Jun 8, 2007 9:09:15 AM
I'm with Spencer - the idea that there are no "profits" in economics means that, in the long run, a given industry will have profits equal to the real interest rate (plus whatever risk premia there may be). I think this is clear is Daniel's post, however.
That said, what's not clear in his post is what's meant by all firms in the economy making profits greater than R. To be honest, I don't even know how this is possible with public firms. If firms in a given sector are making profits greater than R, investment flows to that sector until they no longer make those profits.
If anything, I'd bet the economy as a whole makes less than R return, because many entrepreneurs are willing to lose money in expectation (witness, say, small restauranters, who go into business despite the expected loss for new restaurants).
What evidence is there of these economy-wide, long-run profits above R?
Posted by: cure at Jun 8, 2007 9:21:12 AM
But is the offered statistic from the National Income Accounts the right fact to explain? Cash compensation to CEOs is counted as labor income rather than profits, yet this compensation is better construed as a share of profits carved off in a (positive sum?) game with shareholders. It might be disequilibrium, but it's a persistent, accelerating trend. A component of "consumption of fixed capital" might be another example -- if the capital is expended by the firm for the preferences of the owners. (Depreciation on the bust of the president in the lobby? On the private jet to avoid security lines? On Trump Tower?)
Posted by: Monkey Daddy at Jun 8, 2007 9:30:53 AM
Wow, I thought I only saw Daniel Davies's argument on forums populated by younger, less-educated people. You know what I'm talking about:
"Milton Friedman said businesses should just try to make profits. But isn't this impossible since profits are
supposed to be zero?"
In reality, the claim is only that profits *in one market* *go to zero* in the long run. We're not in the
long run -- we never are -- and markets are produced and destroyed every day. So we shouldn't be surprised
that someone's always making a profit -- that's why people go into business.
Am I missing something here?
Posted by: Person at Jun 8, 2007 9:39:45 AM
I'm confused.
Doesn't the "zero-profit condition" include opportunity costs?
And doesn't the zero-profit condition vanish when increasing returns (such as externalities) are included, such as in endogenous growth models?
And doesn't our accounting of profits include rents from land?
Posted by: Mr. Noah at Jun 8, 2007 11:23:00 AM
Person,
As far as I can tell, you are missing nothing.
Alex,
Amen to the last part.
Posted by: Yancey Ward at Jun 8, 2007 11:32:41 AM
Don't economists typically make stronger claims than what Person is suggesting?
I've seen the Undercover Economist, for example, argue that if you get charged $20 for internet access at a hotel, you know you must be getting a good deal on your room because the hotel industry is competitive and economic profits are 0.
Posted by: Barbar at Jun 8, 2007 12:04:00 PM
Innovation and entrepreneurship typically bring some market power but disequilibrium monopoly has very different implications for policy than equilibrium monopoly.
Sounds exactly right to me -- innovation and entrepreneurship lead to market power which leads to profits, but that market power does not last.
A lovely case in point--Motorola and the Razr.
Market power -> profits:
http://www.businessweek.com/technology/content/oct2005/tc20051018_039341.htm
Oops:
http://www.iht.com/articles/2007/02/02/business/phone.php
Posted by: Slocum at Jun 8, 2007 1:07:06 PM
"I've seen the Undercover Economist, for example, argue that if you get charged $20 for internet access at a hotel, you know you must be getting a good deal on your room because the hotel industry is competitive and economic profits are 0."
More accurately, you're getting a good deal as long as you don't shell out for the internet access (at the expense of those do shell out).
It bugs me that so much of this sort of price discrimination cuts along cognitive lines. I think that sort of price discrimination that gives smart people better deals at the expense of dumb people is getting so pervasive. I think there's some argument for stopping some of this darwinian rent seeking.
Posted by: Keith at Jun 8, 2007 1:07:22 PM
I think there's some argument for stopping some of this darwinian rent seeking.
Why? This instance of price discrimination is not targeted to dumb people, but to wealthy customers whose demand for internet access is more price-inelastic. There's no rent-seeking involved: the hotel's income goes to pay the normal rent of land.
Posted by: guest at Jun 8, 2007 1:23:45 PM
Barber: The relevant "market" in that case would be, not "the hotel industry", but the "hotel room rental/
internet-access-option combo" market, and I suspect his claim was actually that *by the time of his writing*,
switching the package offered to consumer would not change profits much, so the remaining product composition
had to be what he described. This of course, still assumes away latent inefficiencies in how different
hotels happen to be run (maybe right now they have lazy managers?), but still explains most of the
phenomenon.
I'd actually like to add here that I still think there's some truth the "monopoly" bit, but that's an artifact of how you define "monopoly". For example, if along a street, we have Alice's house, then Store A, then Store B, than Bob's house, and Stores A and B are identical, you can still say that Store A gets "monopoly rents" due to being closer to Alice, and B from being closer to Bob. Products are never completely equal, and people always have pick one over the other.
Posted by: Person at Jun 8, 2007 2:34:49 PM
Drug, high tech(3M), and software(Microsoft) companies have monopolies and market power granted them by the government with copyrights and patents. They are an ever increasing part of GDP and their effect can be seen in rise in the average return on sales for US industry over the last 40 years from about 5.5 to 6.5 percent. Their profits can be seen as a return to innovation, so are not necessarily inefficient, but may could have effects on policy prescriptions that are different than that of competitive market models.
Posted by: Joan at Jun 8, 2007 3:00:16 PM
the entire capitalist economy depends on the existence of profits.
Aren't you conflating profit with return to capital here? The capitalist economy certainly depends on capital earning a return. I don't think it depends on the existence of economic profits.
Posted by: Bernard Yomtov at Jun 8, 2007 4:28:43 PM
Prof. AT,
Is the income received by corporate executives calculated into the 5-10% figure for profits? The argument to include it is that even though such pay rates are subject to market conditions, the compensation seems disproportionately high. Among the corporate elite, do we have wage-fixing issue such that the rates are unreasonably high enough to be considered profits as opposed to wages?
Posted by: Chairman Mao at Jun 8, 2007 5:40:53 PM
If we raise the Austrian view on profits, surely we should mention Israel Kirzner along with Mises, Hayek and Schumpeter. Kirzner distinguished different types af profit in order to highlight his anayltical focus, entreprenureal profit. This is the profit that tends to zero in equilibrium, but is decidedly not zero in the real world. (And though the sum of all profits may be zero and perhaps tends to zero, how could we know that it zero in the real world?)
A normal return on investment is interest and risk premium, not entreprenureal profit. It would exist in an equilibrium world where factors of production are scarce.
Monopoly profit might not tend to zero in equilibrium if the entire stock of a particular factor of production were owned by one individual. Thus diamonds are scarce, but they sell for less than if one entity owned the entire stock and could set prices unilaterally. (Some allege de Beers can do this, but that is an emperical question beyond my scope.) This is the case of a monopoly of a unique resource.
Perhaps some CEO compensation is this type of monopoly profit -- only Jack Welch knew how to run GE most efficiently, so he could earn compensation in excess of normal labor, year after year, by only working 40 hours a week. If he had also put in 20 hours a week at Honeywell, he would have competed away the profits.
Tyler's monopoly profits, sound like temporary profits due to disequilibrium. The first bagel shop in town may do very well by selling fewer bagels than a competitive equilibrium and pricing them above marginal cost. We expect other firms to enter the market and push the returns down to a normal return on investment. However, if a town is so small that it cannot support two bagel shops, perhaps competition never comes. They are still unlikely to earn extraordinary returns for very long, not just because tastes change, but because there are substitutes for bagels (donuts, cereal, eggs) that should flatten most real-life demand curves, limiting the market power.
Enterprenurial profits on the other hand are due to someone noticing undervalued resources and buying it low and selling it high to make a profit. As long as only he sees the opportunity, he can trade the quatity that maximizes his profits. But as soon as others see what is going on they will do what he is doing and compete away the opportunity. It is this arbitrage profit that drives the economy toward equilibrium.
Posted by: John Kunze at Jun 8, 2007 9:34:54 PM
[If firms in a given sector are making profits greater than R, investment flows to that sector until they no longer make those profits. ]
this is an assumption, not an empirical result, and it is kind of my point that neoclassical economics doesn't observe the difference.
[most of proprietor's income is really labor income ]
?????are you sure Alex??? I would be much more likely to characterise a non-negligible part of the "Labour income" as disguised profits being appropriated by CEOs and similar.
In general, everyone seems to be trying to mount a moral defence of profits. I have nothing against profits; profits put bread on my table. I'm just trying to make what I thought was a quite uncontroversial point that since there are so many profits about, a system of economics which relies very heavily indeed on a zero profit equilibrium assumption isn't actually a very good system of economics.
Posted by: dsquared at Jun 9, 2007 4:24:49 PM
[Thus Davies is correct, profits do suggest a role for heterodox economics but it's not the paleo-Keynesian/Marxist heterodoxy that gets the boost but the Austrian heterodoxy of Mises, Hayek and Schumpeter.]
I don't see this at all, by the way and respectfully suggest that anyone using the phrase "Keynesian/Marxist" probably needs a strong defence against charges of bullshitting. It's pretty intrinsic to Chapter 8 Keynesianism that the main motivation for investment is the desire to earn entrepreneurial profits.
Posted by: dsquared at Jun 9, 2007 4:27:01 PM
"a system of economics which relies very heavily indeed on a zero profit equilibrium assumption isn't actually a very good system of economics."
"It's pretty intrinsic to Chapter 8 Keynesianism that the main motivation for investment is the desire to earn entrepreneurial profits."
Entrepreneurship takes things out of equilibrium. This happens constantly which is why the equilibrium with near-zero profits is rarely reached. For products which haven't changed much, they really do reach near zero (think basic pencils or thumbtacks or nails for instance). You just don't buy many of those products for some reason...
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