Profit
Economists conventionally assume that firms attempt to
maximize profit. This assumption has been a source of
controversy, in part simply because the word profit
is a bit nebulous. One might think that it is well defined
because each year thousands of firms announce to the public
exactly what their profits are. Firms compute these profits
by subtracting from their total receipts most cash outlays
plus an allowance for depreciation of capital.1
Profit emerges as a residual--something left over
after costs have been paid.
The problem that economists have with this definition is
that it ignores implicit returns. The ma-and-pa
grocery or restaurant may seem to have a profit when costs
are subtracted from revenues, but this may be only because
the owners do not pay themselves a wage. When their time is
valued at even low levels, the "profit" may disappear. Or
the family farm may have a profit, but only because it
neglects to take into account a return on the land. If this
return is computed on the basis of what rent could be
obtained on the land, and if an allowance is made for the
value of the farmer's labor, there may be little or no
profit.
Much of corporate profit can reflect an implicit return
on investment. If the corporation has a large investment in
capital and this entire investment was financed by
borrowing, then the return on capital is captured in the
interest payments the firm makes. But if the investment is
not financed by borrowing, then the return on it will be
reported as profit in the income statement.
The economic definition of profit is the
difference between revenue and the opportunity cost
of all resources used to produce the items sold. This
definition includes implicit returns as costs. Because
profit is a surplus in this definition, it should not
persist in industries in which entry is easy. Whenever a
surplus exists, new firms should flow into an industry,
bidding up the price of resources and bidding down the price
of output until profit in the economic definition is
eliminated. Profit should not exist in long-run
equilibrium.
Profit does exist in the real
world, and there are several explanations that economists
have for it. Some economists simply consider it as an
indication that the economic system is in perpetual
disequilibrium. Joseph Schumpeter, for example, saw profit
as a return to a successful entrepreneur. The
entrepreneur who finds an opportunity where no one before
him saw one, and takes advantage of this opportunity, will
make a profit. However, this profit will be temporary
because, as time goes on, others will follow him and erode
his profit. Others see profit as an indication that forces
of competition may not be strong and that in some industries
barriers to entry exist. Still other economists have argued
that profit is a special sort of implicit return, a return
for bearing risk. Those who are willing to take more risk
will, on the average, earn higher returns.
After one includes implicit costs as part of costs, an
accurate measurement of profit is impossible, which is a
major reason why accountants do not try to measure the
economic concept of profit. This obviously causes problems
if one wants to test whether or not firms try to maximize
profits. An alternative way to approach the measurement
problem begins with the Schumpeterian notion of profit,
which is that it comes from the discovery of opportunity. A
discovery of an opportunity should increase the discoverer's
wealth. Thus, a way to measure profit is to try to measure
unexpected changes in wealth--wealth increasing faster than
a normal rate of return. If one sees people whose wealth is
increasing more rapidly than it would if their assets were
entirely in the form of high-grade, short-term bonds, one
could conclude that they had found a profitable opportunity.
There are measurement problems here as well, however. Much
of people's assets are in the form of investment in
themselves--human capital--and is not easily
measured.
Do firms try to maximize profits? If profit is defined as
accountants measure it, it seems unlikely that firms do.
However, if costs are defined broadly enough, it must be
maximized if the decision-maker is rational because profit
is good for the firm. For example, suppose a humanitarian
opened a business with a goal of helping the poor. He might
keep prices below a level at which accounting profits are
maximized. Yet one can argue that if the humanitarian raises
prices, his (opportunity) costs increase because he must
partially forgo the goal of helping the poor. Thus, with a
loose enough definition of cost, one can argue that a very
wide assortment of observed results are consistent with the
assumption of profit maximization. (However, with a very
loose definition of costs, the hypothesis will cease being a
scientific hypothesis because it will not be open to
refutation.)
Even if there were no definitional problems, there still
would be a fundamental problem with the assumption that
firms maximize profits. Most firms do not have a single
decision-maker. Instead, they are made up of an assortment
of individuals, each using the firm to attain his own goals.
Managers pursue goals; stockholders pursue goals; blue and
white-collar workers pursue goals; but the firm does
not.
The assumption that firms attempt to maximize profits is
inconsistent with the underlying methodology of
microeconomics, which assumes that all decision-makers are
individuals. Mainstream economists criticize Marxists (those
who follow Karl Marx) for dealing in terms of class actions
without grounding these actions on individuals pursuing
goals. Given that most production takes place in firms that
are large organizations, the assumption that firms attempt
to maximize profits is open to the same criticism that
mainstream economists make against the Marxists. The
assumption that firms maximize profits also needs to be
grounded on individuals pursuing goals.
One attempt to ground the assumption of profit
maximization on individual behavior appeals to the
principal-agent problem. An agent acts on behalf of
another person, called a principal. How can the principal be
sure that the agent acts in the principal's interest? The
principal must restrict the agent in some way so that it is
in the agent's interest to act in the interest of the
principal. The most common way to do this is to tie rewards
with performance.
Payment on a commission basis is an important way to
solve the principal-agent problem. When one hires a lawyer
to sue on a civil matter, an auctioneer to sell one's
belongings, or a real-estate agent to sell one's house, or
when a movie star hires an agent to seek employment, payment
is done with commissions. When the agent does a good job, he
or she is paid a lot. When the agent does a poor job, he or
she is paid little or nothing.
Sometimes, the principal can protect himself with a
contract that specifies how the task is to be performed and
what the price will be. The ability to use the courts to
enforce the contract protects the principal. Sometimes, the
principal can protect himself by a threat to take the task
elsewhere. This threat is effective if repeat business is
important to the agent.
The principal-agent problem is one of control: how does
the principal control those working on his behalf? Once one
starts looking for cases of this problem, one finds them
everywhere. How do shareholders control management, citizens
control government, or management control employees? The
principal-agent problem is everywhere because we live in a
world of interdependence and specialization.
The principal-agent problem occurs in several places in
the firm, including in the relationship between legal owners
and hired managers. Stockholders own shares because they
believe that this ownership will increase their wealth.
Managers work for the firm primarily because it provides
them with income needed to buy goods and services, and also
because their positions provide them with prestige and
authority. The threat of a takeover or hostile merger
provides stockholders with their most effective constraint
on managerial action. If managers perform poorly at making
profits, shareholders will sell their shares because they
will not achieve their goal of increasing wealth. The lower
value of the company is an inducement for other management
groups to buy out the company and replace management. If the
new managers can improve performance, they can capture at
least some of the increased value of the firm.
Next we consider the alternative assumption that firms
simply try to survive.
1This is the accounting
definition of profit greatly simplified. There are in fact
many technicalities that complicate this computation, but
they need not concern us here.
Copyright
Robert Schenk
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