Element 1.7: Profits Are a Guide to Productivity

“Profit is not the proper end and aim of management – it is what makes all of the proper ends and aims possible.”

Businesses purchase (or rent) natural resources, labor, capital (machines, tools, and other productive assets), and entrepreneurial talent. These productive resources are then transformed into goods and services that are sold to consumers. In a market economy, producers must bid resources away from their alternative uses because the owners of the resources will supply them only at prices at least equal to what they could earn elsewhere. The payments required to bid the resources away from their other potential uses are a producer’s opportunity cost of supplying a good or service.

There is an important difference between the opportunity cost of production and standard accounting measures of cost of the business firm. Accountants focus on the calculation of the firm’s net income, which is slightly different from economic profit because it omits the opportunity cost of assets owned by the firm. Economists consider the fact that the assets can be used in alternative ways. Accountants also omit the value of the time and effort that owners put into their business over and above what they are paid in salary.

While accountants omit these opportunity costs, economists do not.⁽⁷⁾ The butcher on the corner might close down and rent her shop to another store. She might also take a job in the local supermarket. Both of these are real costs of remaining a butcher. As a result, the firm’s net income will overstate profit, as measured by the economist. Unless these opportunity costs are covered, profits will eventually diminish and resources will be shifted to other productive activities.

A firm’s profit can be calculated in the following manner:

Profit = Total Revenue − Total Cost

The firm’s total revenue is simply the sales price of all goods sold (P) times the quantity (Q) of all goods sold. In order to earn a profit, a firm must generate more revenue from the sale of its product than the opportunity cost of the resources required to make it. Thus, a firm will earn a profit only if it is able to produce a good or service that consumers value more than the cost of the resources required for its production.

Consumers will not purchase a good unless they value it as much, or more, than the price. If consumers are willing to pay more than the production costs, then the decision by the producer to bid the resources away from alternative uses is a profitable one. Profit is a reward for transforming resources into something of greater value than costs.

Business decision-makers will seek to undertake production of goods and services that will generate profit. On the other hand, things do not always turn out as expected. Sometimes business firms are unable to sell their products at prices that cover costs. Losses occur when the total revenue from sales is less than the opportunity cost of the resources used to produce a good or service. Losses impose a penalty on firms when they produce goods and services that consumers value less than the resources required for their production. The losses indicate that the resources would have been better used producing other things.

Suppose, in Bulgaria (where the currency is the Bulgarian Lev, BGN), it costs a shirt manufacturer BGN 20,000 per month to lease a building, rent the required machines, and purchase the labor, cloth, buttons, and other materials necessary to produce and market one thousand shirts per month. If the firm sells the one thousand shirts for BGN 22 each, monthly revenue is BGN 22,000. Profit is BGN 2,000. The firm has created wealth. By their willingness to pay more than the costs of production, consumers reveal they value the shirts more than the resources required for their production. The firm’s profit is a reward for increasing the value of resources by converting them into the more highly valued product.

On the other hand, if the demand for shirts declines and they can be sold only for BGN 17 each, then the firm will earn BGN 17,000, losing BGN 3,000 a month. This loss occurs because the firm’s actions reduced the value of the resources used. The shirts—the final product—were worth less to consumers than the value of other things that could have been produced with the resources. We are not saying that consumers consciously know that the resources used to make the shirts would have been more valuable if converted into some other product. Their combined choices, however, and the prices they are willing to pay provide valuable information to the firm, along with creating an incentive to take steps to reduce the loss. In the example above, the firm was in some sense “surprised” by the unexpected low price of their shirts, for this reason, producers typically spend a great deal of money and effort trying to anticipate demand for their products, thereby creating a large number of jobs for economists as well as tailors.

In a market economy, losses and business failures work constantly to bring inefficient activities—such as producing shirts that sell for less than their cost—to a halt. Losses and business failures will redirect the resources toward the production of other goods that are valued more highly. Thus, even though business failures are often painful for the owners, investors, and employees involved, there is a positive side. They release resources that can be directed toward wealth-creating activities.

The people of a nation will be better off if resources—available land, buildings, labor, and entrepreneurial talent—produce valuable goods and services. At any given time, an endless array of investment activities can be undertaken. Some of these investments will increase the value of resources by transforming them into goods and services that consumers value more highly than cost. These will promote economic progress. Other investments will reduce the value of resources and slow economic progress. If we are going to be wise stewards of available resources, activities that increase value must be encouraged, while those that use resources counterproductively must be discouraged. This is precisely what profits and losses do.

We live in a world of changing tastes and technology, changing government policies, imperfect knowledge, and uncertainty. Business owners cannot know with certainty the future of market prices or production costs. Their decisions are based on expectations. As a student you may spend far more this year for tuition and books than you could possibly earn now in the job you give up in order to study. You do this because you expect the rewards to increase in future periods.

A researcher (often a firm) with an idea for a new breakthrough drug to treat cancer may spend hundreds of millions of dollars before making a single sale. On the other hand, unless the government regulates prices in a way that these “up-front” costs cannot be recovered, the investment in the new cure will be made. It is still the reward-penalty structure of a market economy that is clear. If you think about it, the issue of drug invention is interesting. The sales of a medication that works must also recover all the money invested in ones that don’t work out. A pill that sells for thousands of dollars may actually cost only pennies to produce once it passes all the tests to get to market. Many developed nations ban imports of drug from abroad, not because they don’t think they are safe, but more often (although they don’t tell consumers this) as a form of “foreign aid” whereby life-saving medications can be sold to citizens in developing countries at close to their production cost while the health care system in the developed country bears the development cost.

Entrepreneurs who produce efficiently and correctly anticipate the goods and services that attract consumers at prices above production costs will prosper. Those that do not, will not prosper. Entrepreneurship and business ownership are not synonymous. There is an inclination to think that entrepreneurs are always the owners of a firm, but this is not necessarily the case. Owners, particularly large corporations with many shareholders, often retain entrepreneurs who provide the firm’s strategy and direction. Similarly, entrepreneurs often seek investors who provide financial capital in the form of ownership shares, even though the entrepreneur will determine the direction of the business.

Entrepreneurship typically involves high degrees of financial risk. Some criticize the fact that business failures can accompany the market process. Business owners who allocate resources inefficiently, into areas where demand is such that the firm is unable to cover its costs, will face losses, financial difficulties and, if they don’t adapt will eventually go out of business. Think for a moment about how this private enterprise behavior differs from that of governments which, as we will discuss later, can force customers (taxpayers) to buy services to which they attach little value.

Interestingly, many entrepreneurs who initially flounder or fail eventually succeed in a big way. For example, after leaving Apple in 1985 Steve Jobs founded NeXT, the firm he thought would produce the next generation of personal computers. After Apple suffered a three-year tailspin of serious losses and falling stock prices in the 1990s, it bought NeXT and brought back Steve Jobs in 1997. Soon after, he reorganized Apple and introduced the iPhone, the iPad, plus many other innovative, highly profitable products and services that have continued to succeed spectacularly in the marketplace.

The bottom line is straightforward: profits direct business investment toward productive projects that promote economic progress, while losses channel resources away from projects that are counterproductive. This is a vitally important function. Economies that fail to perform this function well will almost surely stagnate or even regress.