What is Profit?

In neoclassical macroeconomic models that assume perfect competition, there can in the long run be no such thing as profit — defined as revenue left over after all costs have been subtracted.

Clearly, in the real world where many businesses have lived and died profitably there is no such thing as perfect competition, and therefore the neoclassical models that treat profit as a short-run anomaly are working from an unrealistic assumption.

My definition of profit is that profit is what happens when a business’s input transactions are priced less than its output transactions. That is, the sum of the cost of a business’s inputs from those it buys is transacted for a lower price than the sum of those it sells its goods and services to. Because transactions are assumed to be voluntary — and when they are not voluntary, any residual gain is theft, not profit — and businesses are assumed to try to negotiate the best price in both inputs and outputs, any profit is due to those who purchase the business’s output valuing the output higher than those who sold the business its inputs. That an output or input transactor would accept a profit-creating price could be for any number of perceived reasons: convenience, or expertise, or prestige, or necessity, or even outright trickery. Their decision to accept the price is subject to their own subjective valuation, and it is the difference between prices that creates the profit.

Marx and Lenin represented this idea as surplus value; that businesses make a profit by extracting uncompensated labour value out of their workers. But why not the other transactors? In my view, profit is derived from the sum of the business’s transactions with all of its transactors: consumers, supplies, labour (etc). Workers (etc) cannot extract a greater share of the firm’s revenue than they can negotiate, and at various points in history (including the present day) the working class seems to have had little real leverage for negotiation.

In my view, any model that attempts to represent real world markets should begin from the historical fact of profit and loss, and the historical fact of a disequilibrium between input transactions and output transactions.

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16 thoughts on “What is Profit?

  1. I think this great post does your excellent post due respect:

    http://coppolacomment.blogspot.com.au/2012/10/reflections-on-fear.html

    Lest we forget, Galileo Galilei realised that science could not explain all imaginable human questions, even though he played a major role in the scientific revolution, writing that the idea of “understanding everything” involves a “vain presumption”, and that:

    “there is not a single effect in nature…such that the most ingenious theorist…can arrive at a complete understanding of it”

    A few years later, Friedrich Nietzsche also noted that:

    ‘A ‘scientific’ interpretation of the world … might … be one of the most stupid of all possible interpretations of the world, meaning that it would be one of the poorest in meaning. This thought is intended for the ears and consciences of our mechanists who nowadays like to pass as philosophers and insist that mechanics is the doctrine of the first and last laws on which all existence must be based as on a ground floor. But an essentially mechanical world would be an essentially meaningless world. Assuming that one estimated the value of a piece of music according to how much of it can be counted, calculated, and expressed in formulas: how absurd would such a ‘scientific’ estimation of music be! Nothing, really nothing of what is ‘music’ in it!’

    Jerry Seinfeld channels Galileo Galilei while noting mood cannot be seriously reduced to any series of scientific explanations

  2. According to Hicks, “Profit is the maximum amount that an individual can consume within a period and still be as well off at the end of the period as they were at the beginning”. Or something very similar.

    Classical economics does not assume profit does not exists in the long run. Instead it holds that a normal profit is a cost (unlike accountants whose see profits as a residual after costs have been accounted for). The classical economists hold that any profit above normal profit is super profit.

  3. Profit should be what remains from revenue after the REAL costs are deducted. Correct calculation of Depreciation is a big problem. If you don’t compensate your worn out capital correctly profit is incorrect. Inflation Accounting is crucial in high inflation environments. Raw Materials consumed must reflect current prices.

    I disagree with the Surplus Value idea of Marx.

    All workers should undertake a small profit making venture, just to understand what it is like to put ones capital on the line, and then employ someone to assist them.

    This would then give them a better position to negotiate. They will not negotiate such a high price as to cause the business to collapse. Union officials should also undertake a profit making venture.

    An honest days work for an honest days pay. That is the maxim that builds capital for canny individuals willing to take a risk and the wealth of nations (The wealth of the labourers)

    Employee share schemes are the best incentive as it aligns the workers to the profit outcome of the business. Slackers are quickly ostracised, because they are undermining the collective workforce.

  4. When you diverge from the relationship between single producer and single consumer, you sequentially add variability that obscures ones ability to understand the new relationships.

    This is why it is so easy for people within the financial community to create “products” that nobody understands. The layers of increasing complexity are put in place by the legions of interests all seeking their free lunch.

    The science of economics is in place only as a cover. It makes no more sense than does waving a magic wand or intoning ones favorite incantation.

  5. I don’t know about the UK or US but in Australia our largest retail supermarket chains are placing huge pressure on suppliers and farmers.

    Is the profit made by the Supermarkets profit? If the prices paid do not reflect long term viability of farming or manufacture, then these profits are only short term, because once the suppliers go bust (Can’t make return on capital for risk) and the Supermarkets are more reliant on imported goods, then in the event of a currency collapse, and rampant supply cost increases, how will they pass these costs on to the consumer? They can’t. Therefore the profit made initially is wiped out by the losses.

  6. You’ve left out the rate of interest. In any kind of business in the theoretical super long run income – cost =/= 0, but it equals interest rate. After all you have to buy equipment and pay initial wages before you can sell first batch of products. If you would not get at least interest rate out of it – this business should be closed, as it is failed venture. You need to get something back for the time put into production, or in “stabilized” super-long-run market nobody would do this.

    Guys making first viable mobile phone have huge demand, can rise price a lot and get huge profits. Competition moves from other branches and eventually profits fall, but if they go down to interest rate no one else is coming. It doesn’t go down to zero (unless it’s bad calculation on some firms part).

    Also, in some kind of World where there are marvelous ways of adding value, great techniques to get wanted products from factors even if progress at some point stops and there is nothing new to make you will still get huge returns on business activity. But uniform all over the economy as all branches eventually equalize towards interest rate.

  7. Just out of curiosity – doesn’t perfect competition actually only occur when the number of firms approaches infinity? That’s how MR curves become flat, correct? The existence of profit in the nc model is more so that the number of firms has to be finite and so MR curves have to be somewhat upward sloping?

    • That’s correct. And models that assume perfect competition also assume infinite firms. And if we’re assuming infinite firms, what can that really tell us about reality?

    • Fair point. What about the retail revolution due to the internet. Prices have come down to the point where retailers are a sub contractor of the manufacturer. Wholesalers share has been decimated.

      With 3D printing and internet dispersal, competition approaches theoretical perfection.

  8. Neoclassical economics is completely filled with nonsense. Steve Keen completely trashes it in every single way possible in his book Debunking Economics. Every single part.

    Rather than using bullshit starting assumptions, why don’t they use assumptions based on the empirical evidence. I was lucky in the sense that the first thing my first macroeconomics teacher said was that you always have to check everything against the data. Both the assumptions and the results. He also stated the importance of understanding that economics is a social science and he really emphasized that. Unfortunately, my other econ teachers weren’t like that and spewed bullshit that he basically showed was garbage. Economics needs to change completely.

    We need a new approach to economics combined with a new way of thinking.

  9. On the one hand, we all seem to agree that these formulas and definitions are meaningless, but on the other, we keep going back to explore their true meaning.

    If you have ever run a business, you intimately understand that profit is what’s left after you pay all of your bills. The variability of the factors which come together to determine your costs as well as your selling price are infinite and therefore unknowable.

    • There are known knowns – Bills and unknown unknowns – Government Policy

      There are known unknowns – Actual Sales to Budget estimates.

      Making a profit is tough!

      “ [T]here are known knowns; there are things we know that we know.
      There are known unknowns; that is to say there are things that, we now know we don’t know.
      But there are also unknown unknowns – there are things we do not know we don’t know. ”
      —United States Secretary of Defense, Donald Rumsfeld

  10. Pingback: What is Profit? | My Blog

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