Thursday, 6 March 2008

Profit is not a dirty word

"Never speak to me of profit," mid-twentieth century Indian leader Pandit Nehru once said to an industrialist. "It's a dirty word."
(Roger Kerr, "Prejudice against a word", The Otago Daily Times - 16 January 2004.)
Most business in New Zealand are small. According to Roger Kerr in a recent article in the Otago Daily Times there are around 413,000 businesses around the country employing five or fewer employees. Also according to Kerr large businesses, that is those employing 100 or more make up only 0.5% of all businesses, but employ 46% of the total work force. Thus business are important to society as providers of jobs and income. In fact most economic activity takes place within firms, not in markets. Economist John McMillan estimates that less than a third of all transactions in the U.S. economy occur through markets and over 70 percent occur within firms.

Kerr also makes the important point that all these business set out to meet the needs of consumers, that's how they make profit, its how they stay in business. The main function of any firm is to be an efficient producer of goods and services that consumers value. By making what consumers want, at a price consumers are willing to pay, firms make profits. That is, profits are a signal that consumers value the good or service being produced more than the firm values the resources used in its production. They are also a signal to other firms that maybe they should enter the market: in the hope of also making positive profits. In this way profits attract new firms into markets, thereby increasing competition in that market and forcing businesses compete with one another to be more innovative and resourceful and in the process they drive down prices and give better value for the customer's dollar. This competitive process lends to good use of resources, resources are used efficiently to produce the goods and services people want. Such competition would result in profits being driven to zero, in equilibrium, should we ever get there. This in turn tells firms to stop entering the market and to go and look for other, more profitable, ways to apply their resources. It is this constant searching for profit that drives innovation and that has brought lower priced and better quality goods to consumers.

On the other hand losses tell firms the opposite, to stop what they are doing as consumers do not value their goods highly enough to make production worth while. Firms then switch into another line of business or go out of business and their assets are transferred to others who think they can use them in a profitable way. It may seem a harsh way of allocating resources in an economy. But it is the best way we have yet found. Just look at economies, like the old Soviet Union, which tried to allocate resources without the profit motive to appreciate this point.

No comments: