Economics in One Lesson

by Henry Hazlitt

The Lesson Applied

The Function of Profits


The indignation shown by many people today at the mention of the very word profits indicates how little understanding there is of the vital function that profits play in our economy. To increase our understanding, we shall go over again some of the ground already covered in chapter fifteen on the price system, but we shall view the subject from a different angle.

Profits actually do not bulk large in our total economy. The net income of incorporated business in the fifteen years from 1929 to 1943, to take some illustrative figures, averaged less than percent of the total national income. Corporate profits after taxes in the five years from 1956 to 1960 averaged less than 6 percent of the national income. Corporate profits after taxes in the five years 1971 through 1977 also averaged less than 6 percent of the national income (in spite of the fact that, as a result of insufficient accounting adjustment for inflation, they were probably overstated).10 Yet profits are the form of income toward which there is most hostility. It is significant that while there is a word profiteer to stigmatize those who make allegedly excessive profits, there is no such word as “wageer”—or “losseer.” Yet the profits of the owner of a barbershop may average much less not merely than the salary of a motion picture star or the hired head of a steel corporation, but less even than the average wage for skilled labor.

The subject is clouded by all sorts of factual misconceptions. The total profits of General Motors, the greatest industrial corporation in the world, are taken as if they were typical rather than exceptional. Few people are acquainted with the mortality rates for business concerns. They do not know (to quote from the TNEC studies) that “should conditions of business averaging the experience of the last fifty years prevail, about seven of each ten grocery stores opening today will survive into their second year; only four of the ten may expect to celebrate their fourth birthday.” They do not know that in every year from 1930 to 1938, in the income tax statistics, the number of corporations that showed a loss exceeded the number that showed a profit.

How much do profits, on the average, amount to?

This question is commonly answered by citing the kind of figures I presented at the beginning of this chapter—that corporate profits average less than 6 percent of the national income — or by pointing out that the average profits after income taxes of all manufacturing corporations are less than five cents per dollar of sales. (For the five years 1971 through 1975, for example, the figure was only 4.6 cents.) [11] But these official figures, though they fall far below popular notions of the size of profits, apply only to corporation results, calculated by conventional methods of accounting. No trustworthy estimate has been made that takes into account all kinds of activity, unincorporated as well as incorporated business, and a sufficient number of good and bad years. But some eminent economists believe that over a long period of years, after allowance is made for all losses, for a minimum “riskless” interest on invested capital, and for an imputed “reasonable” wage value of the services of people who run their own business, no net profit at all may be left over, and that there may even be a net loss. This is not at all because entrepreneurs (people who go into business for themselves) are intentional philanthropists, but because their optimism and self-confidence too often lead them into ventures that do not or cannot succeed) [*]

It is clear, in any case, that any individual placing venture capital runs a risk not only of earning no return but of losing his whole principal. In the past it has been the lure of high profits in special firms or industries that has led him to take that great risk. But if profits are limited to a maximum of, say, 10 percent or some similar figure, while the risk of losing one’s entire capital still exists, what is likely to be the effect on the profit incentive, and hence on employment and production? The World War II excess-profits tax showed what such a limit can do, even for a short period, in undermining efficiency.

Yet governmental policy almost everywhere today tends to assume that production will go on automatically, no matter what is done to discourage it. One of the greatest dangers to world production today still comes from government price-fixing policies. Not only do these policies put one item after another out of production by leaving no incentive to make it, but their long-run effect is to prevent a balance of production in accordance with the actual demands of consumers. When the economy is free, demand so acts that some branches of production make what some government officials regard as “excessive,” “unreasonable,” or even “obscene” profits. But that very fact not only causes every firm in that line to expand its production to the utmost, and to reinvest its profits in more machinery and more employment; it also attracts new investors and producers from everywhere, until production in that line is great enough to meet demand, and the profits in it again fall to (or below) the general average level.

In a free economy, in which wages, costs and prices are left to the free play of the competitive market, the prospect of profits decides what articles will be made, and in what quantities—and what articles will not be made at all. If there is no profit in making an article, it is a sign that the labor and capital devoted to its production are misdirected: the value of the resources that must be used up in making the article is greater than the value of the article itself.

One function of profits, in brief, is to guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand. No bureaucrat, no matter how brilliant, can solve this problem arbitrarily. Free prices and free profits will maximize production and relieve shortages quicker than any other system. Arbitrarily fixed prices and arbitrarily limited profits can only prolong shortages and reduce production and employment.

The function of profits, finally, is to put constant and unremitting pressure on the head of every competitive business to introduce further economies and efficiencies, no matter to what stage these may already have been brought. In good times he does this to increase his profits further, in normal times he does it to keep ahead of his competitors, in bad times he may have to do it to survive at all. For profits may not only go to zero, they may quickly turn into losses; and a man will put forth greater efforts to save himself from ruin than he will merely to improve his position.

Contrary to a popular impression, profits are achieved not by raising prices, but by introducing economies and efficiencies that cut costs of production. It seldom happens (and unless there is a monopoly it never happens over a long period) that every firm in an industry makes a profit. The price charged by all firms for the same commodity or service must be the same; those who try to charge a higher price do not find buyers. Therefore the largest profits go to the firms that have achieved the lowest costs of production. These expand at the expense of the inefficient firms with higher costs. It is thus that the consumer and the public are served.

Profits, in short, resulting from the relationships of costs to prices, not only tell us which goods it is most economical to make, but which are the most economical ways to make them. These questions must be answered by a socialist system no less than by a capitalist one; they must be answered by any conceivable economic system; and for the overwhelming bulk of the commodities and services that are produced, the answers supplied by profit and loss under competitive free enterprise are incomparably superior to those that could be obtained by any other method.

I have been putting my emphasis on the tendency to reduce costs of production because this is the function of profit-and-loss that seems to be least appreciated. Greater profit goes, of course, to the man who makes a better mousetrap than his neighbor as well as to the man who makes one more efficiently. But the function of profit in rewarding and stimulating superior quality and innovation has always been recognized.

* Cf. Frank H. Knight, Risk, Uncertainty and Profit (1921). In any period in which there has been net capital accumulation, however, the presumption is strong that there must also have been overall net profits from previous investment.