The Paradox of Profits Part 2. Why we need the profit system

In the first essay in this series, I discussed the problematic nature of individual profits from the standpoint of justice. In this essay, I explain why a profit system is the most effective, humane way to organize economic activity. Or, as Winston Churchill once said about democracy, it is the second worst way to organize an economy, and all the others are tied for the worst.

Humane but Primitive

You might think that the most humane way to run an economy would be to use deliberation and consensus. And this might work if we had a small, self-contained economic unit, a village of 150 people or less.

But with 150 people in a self-contained village, you are restricted to a primitive economy. By self-contained, I mean that everything that we are able to consume has to be produced in the village, from start to finish. We could not use modern farm implements, because our village does not have enough people to produce them. Forget about modern medicine, electronics, plumbing, and all the rest.

What we have come to expect from economic life cannot be procured without extensive specialization and trade. Ultimately, the work of millions of people goes into creating the goods and services that we enjoy in a modern economy.

Bosses and Profits

In a modern, large-scale economy, coordination takes place through a combination of bosses and profits. Bosses order people to undertake particular tasks. Profits and losses provide incentives to engage in certain economic activities and to curtail others.

Within any one organization, you take orders from a boss. Your only alternative is to leave that organization and find another boss or start your own organization.

Profits determine the success or failure of different organizations. Organizations that earn profits can continue to operate. Organizations that fail to earn profits have to go out of business, unless they can survive on donations or subsidies.

The profit system helps to discipline bosses. Really bad bosses, who use resources inefficiently (including mis-use of workers), tend to perform poorly in terms of profits. This poor performance eventually gets weeded out, either by the boss’s boss or by the inability of a poorly-performing firm to stay in business.

Profits and Sustainability

Profits are a measure of economic sustainability. A business earns a profit if it offers to consumers something that is more valuable than the costs of the resources used by the business to provide its goods and services. For the most part, a business that earns a profit is using resources efficiently. For the most part, a business that operates at a loss is wasting resources.

When people accuse the market system of using resources unsustainably and they propose alternatives, they are almost always wrong. For example, the ethanol mandate for gasoline almost surely wastes resources. Overall, it probably increases carbon dioxide in the atmosphere, because it encourages more land to be covered with corn fields instead of forest.

Mandatory recycling wastes resources. We know that, because if recycling really saved resources, then it would be profitable. If recycling were sustainable, then private firms would pay you for recycled trash; instead, the local government has to mandate recycling and subsidize recycling services. That is a drain on resources.

Government as Boss

Government works by bossing people. This could be directly controlling activity, as when a government runs a school system. Or it could be indirectly controlling people, as when a government issues regulations.

There are good reasons for having at least some government bossing. I have a hard time imagining urban sanitation working well without regulation. There are many other cases where the absence of a central boss would lead to bad outcomes. Economists refer to these cases as “market failures.”

But just because there might be market failure does not mean that we necessarily should take economic decisions away from the profit system and turn those decisions over to a government boss. We might be better off leaving decisions to the market, even though the market is not perfect.

Reasons to Prefer the Profit System

One reason to leave decisions to the profit-and-loss system is that this gives more people more autonomy. Government works by bossing, and that reduces individual autonomy. Yes, in a democracy each of us can vote, but our voting has very little effect on how the government bosses operate. If I disagree with the government’s decision to allocate valuable spectrum to local television stations, I have close to zero chance of having any impact on that decision. As a consumer and as a worker, I do not have to sit back and accept something I do not like. I can “vote with my feet” to go to a different employer or find a different seller.

Another reason to be wary of government bosses is that they are not so smart. When a government boss decides that women under 40 do not need mammograms for breast cancer screening, that boss does not know the circumstances of every woman. The government boss does not know how the state of screening technology is progressing. The government boss does not know how much some women may value the peace of mind that comes from cancer screening.

It is easy for a person to say, “I do not like the market outcome of X. I want to see the government change it.” But when you say that, you are saying that you want to be the boss. And no matter how much you think you know, the chances are that you are not as wise a boss as you think you are. That goes for trained economists, too.

And even if you happen to be the one who is wise about a particular issue, there is no guarantee that the government boss will make the choice that you would make. There is also the phenomenon of “government failure,” and often it is worse than market failure.

Conclusion

A modern economy is going to be coordinated by a combination of the profit/loss system and bosses. Even in Denmark and Sweden, profits and losses play a major rule. Indeed government bosses are in some ways more intrusive in the United States than they are in those “socialist utopias.”

So we are stuck with the paradox of profits. Individual profits are not always just. yet the profit system is necessary for coordinating a modern economy. How should we be trying to deal with this paradox? That will be the subject of the third and final essay in this series.

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