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Why are there no profits in economic theory?
Shouldn't CrookedTimber be the site that covers the heterodoxy? Daniel Davies picks up the slack:
The anomaly I’m talking about is that neoclassical economics, in both macro and micro forms, nearly invariably works on the basis of models in which there are no profits.
Since in general, companies do earn profits, I think this is a pretty big problem.
Do read his caveats.
I usually answer such questions by referring to the ordinary humdrum of my suburban life. It took my three days to buy the new Paul McCartney CD, and yes I do love his solo work, or at least some of it. And can you guess why it took me so long? The CD is available only in Starbucks, but until today each Starbucks was situated so that my exit would have necessitated a left turn across four lanes of crowded traffic (and, most importantly, without a traffic light). I love "Maybe I'm Amazed" as much as the next guy, but this boy just ain't up for those sorts of indignities.
The higher the value of time, the more likely these competitive barriers will arise. So the standard monopoly model explains much more of the economy than most market-oriented economists like to admit. That said, I am less sold on Davies's worry that this has nihilistic consequences for mainstream economics. Tariffs are still usually bad; let's not forget that behavioral imperfections plague politics as well.
Posted by Tyler Cowen on June 7, 2007 at 06:02 PM in Economics | Permalink
Comments
Hmm, my understanding of neoclassical economics is that is assumes the *marginal* company makes no profits - I'm not sure I get what the problem is.
Posted by: Paul N at Jun 7, 2007 6:17:39 PM
As usual, critics of mainstream economics think that the perfect competition model is the only thing there is.
They should take a look at some post-1960 economics.
Posted by: Ramon at Jun 7, 2007 6:25:20 PM
You first have to understand that the definition of Economic profits and Accounting profits are not the same. People must make Accounting profits or they would not be in business. A firm can continue to earn Accounting profits while Economic profits are driven to zero in a competitive market. Economic profits include the opportunity cost of being profitable in any other industry. So when a firm could make the same accounting profit in one industry vs. another the firm is indifferent as to which industry they serve because economic profits are zero.
Posted by: Eric at Jun 7, 2007 6:32:22 PM
Paul, agreed, and moreover, as long as there is a limited supply of investment capital, it usually has better things to do than establish a marginal firm, or expand an existing firm to the marginal limit.
Posted by: Cyrus at Jun 7, 2007 6:35:10 PM
That's an easy question. Unlike neoclassical "firms", real businesses typically own some of the factors of production which they use; hence they receive the income due to those factors. Most commonly, this includes land rent, the yield of capital goods and the entrepreneur's wages of superintendence.
Posted by: guest at Jun 7, 2007 7:12:45 PM
In the real world, corporations are always attempting to get in a situation where they can exploit monopoly power. Sometimes they succeed.
Posted by: Steve Sailer at Jun 7, 2007 8:08:23 PM
In the real world, corporations are always attempting to get in a situation where they can exploit monopoly power. Sometimes they succeed.
Very true. And of course, much of that attempting to get in a situation where they can exploit monopoly power is advancing technology and innovation (and supply chains and organization et al.) Not all of it, to be sure, though government intervention has its own problems.
He's certainly right that an assumption that perfect competition is the norm is flawed. At the same time, it's flawed to think that an economy always in perfect competition is ideal over the long run either, even if it may seem like the best static instantaneous situation.
Posted by: John Thacker at Jun 7, 2007 10:32:04 PM
Darn, all that traffic in the suburbs; kinda spoils the fantasy...
Posted by: Delirious at Jun 7, 2007 11:32:51 PM
In the long run, there are no profits. Truly profitable companies make their profits by refusing to operate in the long run.
Instead they operate in the short runs between market formation and market saturation for their products and services. They redeploy assets to better situated short runs when their older offerings get close to or into the long run.
Profits come to innovators and value creators who keep innovating and value creating.
Posted by: Tom Kelly at Jun 8, 2007 2:02:00 AM
Companies earn no profits. All their earnings go to pay their costs. These costs involve costs of goods sold, the cost of the labor that went into transforming the goods, the (amortized) labor that goes into its capital goods, amortizing the capital goods it owns, paying to rent the capital goods it does not, and paying entrepreneurial profits (which are eventually competed away). Note that any one person may get a cut of one or more of these costs.
But the business itself earns no profits.
Posted by: Russell Nelson at Jun 8, 2007 2:53:59 AM
[Tariffs are still usually bad]
Alex, this result can't be derived in an economy with a positive rate of profit; Ian Steedman proved this one in a series of papers discussed on Rob Vienneau's blog.
Posted by: dsquared at Jun 8, 2007 3:44:30 AM
sorry, Tyler, not Alex!
[Companies earn no profits. All their earnings go to pay their costs. These costs involve [...] entrepreneurial profits [...] But the business itself earns no profits]
If I am similarly allowed to redefine terms, I can prove that a dog has five legs.
Posted by: dsquared at Jun 8, 2007 5:47:43 AM
dsquared, entrepreneurial profits are paid to the entrepreneur as wages of superintendence. In the long run, these are regulated by the labor market just like ordinary wages. When economists say that "businesses earn no profits", they mean that all of their earnings must be accounted for by wages, interest or rent (including monopoly rent).
Posted by: guest at Jun 8, 2007 9:58:06 AM
dsquared, Russel_Nelson, and quest: I think when economists claim profits go to zero, they're talking about
the "entrepreneurial profits" portion in what Russel_Nelson listed, and in the real world, this is not
obviously contradicted. Mainstream economists do not feel the need to reduce all earnings for each corporataion
in each year, in to wages, interest, and rent. (Georgists however, do exactly this, and I've criticized
this with one such economist via email for lumping entrepreneurial profits with wages, given that
they have such different characteristics.)
From what I know, the mainstream has "enterprise" as the fourth factor
of production (labor, capital, and land being the first three, or "classical factors"). Or as I like to say:
Wages of labor,
Interest of time,
Rent of land,
Profit of mind.
German version:
Loehne der Arbeit,
Zinsen der Zeit,
Miete des Landes,
Profit des Verstandes.
Posted by: Person at Jun 8, 2007 10:34:51 AM
Also, don't increasing-returns-to-scale production functions, such as those with externalities, allow for nonzero profits? I recall Romer's endogenous growth models as being an example of that sort of thing.
Posted by: Mr. Noah at Jun 8, 2007 11:24:17 AM
Yeah, Dsquared really went off the rails. Economic profits are only those above opportunity costs. Weird that the fat young man didn't get that.
Posted by: Keith at Jun 8, 2007 1:09:33 PM
There are no economic profits for the same reason most people can't be better than average -- it's true by DEFINITION!
-Mercy
Posted by: Mr. Mercy Vetsel at Jun 8, 2007 6:09:50 PM
CD means intellectual property, and IP is a huge government intervention in the otherwise free market. What do you expect then?
"""
Just to illustrate how great out ignorance of the optimum forms of delimitation of various rights remains - despite our confidence in the indispensability of the general institution of several property - a few remarks about one particuilar form of property may be made. [...]
The difference between these and other kinds of property rights is this: while ownership of material goods guides the user of scarce means to their most important uses, in the case of immaterial goods such as literary productions and technological inventions the ability to produce them is also limited, yet once they have come into existence, they can be indefinitely multiplied and can be made scarce only by law in order to create an inducement to produce such ideas. Yet it is not obvious that such forced scarcity is the most effective way to stimulate the human creative process. I doubt whether there exists a single great work of literature which we would not possess had the author been unable to obtain an exclusive copyright for it; it seems to me that the case for copyright must rest almost entirely on the circumstance that such exceedingly useful works as encyclopaedias, dictionaries, textbooks and other works of reference could not be produced if, once they existed, they could freely be reproduced.
Similarly, recurrent re-examinations of the problem have not demonstrated that the obtainability of patents of invention actually enhances the flow of new technical knowledge rather than leading to wasteful concentration of research on problems whose solution in the near future can be foreseen and where, in consequence of the law, anyone who hits upon a solution a moment before the next gains the right to its exclusive use for a prolonged period.
The Fatal Conceit: The Errors of Socialism, 1988 (p. 35) Friedrich von Hayek
"""
Posted by: Laurent GUERBY at Jun 10, 2007 11:21:18 AM
To address the original question which was: Why are there no profits in economic theory?
There are! However many of the contributors to this discussion seem to be stuck in the static neoclassical, perfectly competitive world where production inputs are land, labor & capital, production functions are linear homogeneous, & markets work perfectly & adjust instantaneously.
Of course such a world does not exist except in the models of abstract theory.
For profit to exist, all that is needed is an entreprenuerial input which has a positive opportunity cost. (There is of course a difficulty in defining & measuring the "entrepreneurial input!)
Positive & negative economic profit (not = OC of the entrepreneurial input) will exist during periods of market adjustment after some disturbance in the market. Monopoly power confers economic profit on those who possess such power, But positive & negative economic profit easily arises in a world where markets are subject to risk & uncertainty.
Some of the contributors are advised to read Frank Knight's "Risk, Uncertainty & Profit" 1921,
Posted by: john rodgers at Jun 20, 2007 4:23:54 AM
