The Concise Guide To Economics
by Jim Cox
3. Profit/Loss System
The free market economy is a profit and loss system. Typically, profits are emphasized but it should be understood that losses are equally necessary for an efficient economy. The nature of profits are sometimes misconstrued by the general public. Profits are not an excess charge or an act of meanness by firms. Profits are a reward to the capitalist-entrepreneur for creating value. To understand this we must first understand the nature of exchange. When two parties trade they do so because they expect to receive something of greater value than that which they surrender; otherwise they would not waste their time engaging in exchanges. Now what is the nature of a profit?
A businessman takes input resources--land, labor, materials, etc.--and recombines them to produce something different.
For example:A car manufacturer takes$4,000 worth of materialsfor a total cost of $11,000,
$6,000 worth of labor
$1,000 worth of overhead
and produces a car which sells for $15,000. The only way the car will sell for this $15,000 is if a consumer willingly parts with the money for the car, and based on the nature of exchange he will do so only if he prefers the car to the money. So the entrepreneur has taken $11,000 worth of resources and refashioned them into a car worth $15,000, thereby making a profit of $4,000. Where did the $4,000 profit come from? The answer is it wascreated by the manufacturer. He caused it to come into existence. This is a creative act just as producing an art work is a creative act.
The worth or value of the materials, labor and overhead is what those items will sell for to willing buyers. By refashioning them into the car, the manufacturer has produced more value than he found in the world. Profits are a sign of value creation; making profits deserves to be hailed and honored for benefitting mankind.
Now, take the example of losses. Are losses an act of kindness and not charging too much? In essence: No. Taking the same example, with input costs of $11,000, what if the manufacturer had produced a car that no one would buy for more than $11,000? If the manufacturer could not sell the car until the price was say, $8,000, then what does this mean? It means he has taken perfectly good resources--materials, labor and overhead--and recombined them in such a manner that they are now worth only $8,000 to buyers. He has destroyed value in the world. Such an act deserves condemnation for impoverishing humanity. Had the businessman not come on the scene the world would have been richer by $3,000 in value.
Fortunately, in the free market we do not have to rely on social honor or condemnation to motivate producers to produce those goods which consumers prefer. This occurs naturally as profits allow successful producers continued production and wider control of resources while losses deprive others of control of resources and the ability to continue in production.
Also, note the beauty of the market: Any failure in serving consumers, irrational pricing or choice of production is to that same degree an opportunity for profits. Thus, the market, while not perfect, is self-correcting. Reformers will better rectify any inadequacies they detect in the market by reaping the profits available from that inadequacy than by denouncing the very system which makes meaningful reform possible.
Profits are a signal to use resources to produce items highly valued by consumers and losses are a signal to discontinue production of low-valued items. Losses are necessary to free up resources for use by those producing valued goods. Therefore we find that the interests of producers and consumers are harmonious, rather than at odds.