Reading: Lesson 3 – The Function of Profits

Description: 

The goal of every business is to make a profit. Profit is money made after accounting for all relevant expenses; it is the difference between revenue (money gained from sales and investment) and expenses (including the costs of making and selling the product, salaries, and any fixed costs such as rent, etc.). Profits incentivize entrepreneurs to allocate resources towards their most productive uses and in ways that provide the most value to consumers. In short, profits play a key role in directing resources to where they are most valued by people in society.

In this lesson, students will watch and discuss a short video about the price system with Professor Daniel Smith. After the video discussion, students will read two articles – ‘The Function of Profits’ by Henry Hazlitt and ‘Letter to Grandson’ by Mr Kent. The first article discusses the role of profits in the market. The second provides an illustrative example about how entrepreneurial profits benefit people in society.

 

Time Required:

45 min

 

Required Materials:

Internet connection, writing instrument 

 

Prerequisites:

Module 3 – How Can Entrepreneurs Use Economics to Make Better Decisions?

Module 4 – How Does Trade Create Wealth?

Lesson 5.1 – Role of Prices

Lesson 5.2 – How Market Prices Emerge

5.3.A – Watch and discuss the following video using the questions below to guide your discussion [15 min]:

Video:  by Dan Smith (Learn Liberty, 3:04 min)

“What is the social function of profits and losses? As Professor Daniel J. Smith of Troy University describes, they provide an incentive for people to follow the information provided by the price system. By pursuing profits and avoiding losses, producers and consumers use scarce resources in effective ways. In anticipation of being rewarded with profit, people and businesses are encouraged to undertake activity that will create valuable outputs. At the same time, the potential for losses encourages them to avoid excessive risks and wasteful activity. Policies that reduce profits, such as taxation, or reduce losses, such as bailouts, disrupt this function of prices and lead to inefficient uses of resources.”

Discussion Questions:  The Price System, Part 2: Profits & Losses

1.  What role do profits play for the entrepreneur?

1. Profits are the reward for an entrepreneur being alert to and successfully acting to satisfy urgently demanded opportunities in the market.
2. The pursuit of profit creates incentives for entrepreneurs to allocate resources towards their most productive uses and in ways that provide the most value to consumers. This creates efficiency in the market and frees up both resources and labor to be used for other purposes.

 

2.  What does Professor Daniel J Smith mean by the statement “Bankruptcy is not a failure of the market”? Should the government intervene in the market to protect large companies against bankruptcy?

1. Professor Daniel J Smith explains “Bankruptcy is not a failure of the market. It is the market working…When that happens, those company’s resources are reallocated to be used by more successful businesses.”
2. In other words, when a company goes bankrupt it is because they have been a poor steward of scarce resources. They are not producing what consumers value in a productive way. Through the bankruptcy process, the inefficiently used or mismanaged resources can be freed for use by other companies that can better satisfy consumer needs.
3. If the government protects companies against bankruptcy, it encourages excessively risky behavior and removes incentives for companies to behave responsibly. This is what economists call moral hazard.

 

5.3.B - Read the following article using the questions below to guide your discussion [15 min]:

Article: Economics in One Lesson - The Function of Profits by Henry Hazlitt (FEE.org)

“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.”

Discussion Questions:  Economics in One Lesson - The Function of Profits

1.  According to Henry Hazlitt, what is the function of profits?

1. Profits incentivize people to produce goods and services that are of value to others. Profits help to direct scarce resources to where they are most urgently needed to satisfy the wants and needs of the people in society. Hazlitt explains the function of profits 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.”
2. Profits also drive businesses to continuously improve the way they serve their customers. The author states that profits will maximize production and minimize shortages as well as put constant pressure on every competitive business to introduce further economies and efficiencies.

 

2.  What are some of the common misconceptions about profit and business the author discusses in the article?

1. There is often a misconception that all businesses make large amounts of profit. The author uses the example of General Motors – one of the biggest companies in the world. People have the perception that the profits of General Motors are incredibly common, when in reality this company is one of the few exceptionally high performing.  [Note: This text was published in 1946. General Motors filed for Chapter 11 bankruptcy in 2009. Even companies that make large profits at one time must continue to serve customers well in order to make ongoing profits.] 
2. People are not aware of how high the rate of failure for businesses is. The article states “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”.
3. There are often negative public sentiments associated with high-performing companies and individuals who make large profits. However, if these companies didn’t exist everyone would be worse off due to higher unemployment in the economy and less goods and services available for consumption.

 

3.  What happens to producers and consumers in the market when the government intervenes to restrict profit opportunities? In what ways might government intervention be self-defeating?

1. If the government intervenes to confiscate large amounts of profit, or puts in place price barriers that restrict the profit opportunities for a particular good, there is less incentive for an entrepreneur to produce it. This leads to some products not being produced at all, causing shortages. One example is the decrease in production that occurred when the government imposed the war-time excess profits tax.
2. Producers lose incentives to produce when profit opportunities are restricted. Correspondingly, producers have less income to be consumer of other products and fewer goods of value available to consume. The general standard of living for people in society tends to fall relative to restrictions of entrepreneurial profit opportunities.

5.3.C - Read the following article using the questions below to guide your discussion [15 min]:

Article: Letter to a Grandson - Mr. Kent (Free Market Foundation)

“Are profits earned at the expense of someone else?”

Discussion Questions:  Letter to a Grandson - Mr. Kent

1.  Using examples from Mr. Kent’s letter, explain how people benefit when an entrepreneur earns high profits.

1. In order to make a profit, entrepreneurs must provide something that gives value to others. In the example in the letter, the entrepreneur who makes a trough of water makes everyone’s life significantly easier by saving those people fifty minutes of their day. The entrepreneur profits by earning the equivalent of 10 minutes of everyone else’s production time. Both the entrepreneur and everyone in the community win because they are all saving themselves time and their lives have become better.
2. People benefit both in terms of a wider range of goods and services they can consume and the time they save from not having to produce those goods by themselves.

 

2.  Why is it essential to have a good legal system that protects private ownership?

1. The letter explores what could happen if there was no legal system to protect private ownership. In the letter, Mr. Kent states, “When the hundredth man had completed his trough down the mountain and said to the other ninety-nine “If you will give me what it takes you 10 minutes to produce, I will let you get water from my basin”, they turned to him and said “We are ninety-nine and you are only one. We will take whatever we want””.
2. Without a reliable legal system to protect private ownership, the entrepreneur would have less incentive to produce and innovate in the first place. This makes everyone in the community worse off.

Lesson Recap

• Profits are the reward for an entrepreneur being alert to (and successfully acting to) satisfy the most urgently demanded opportunities in the market.

 

• Profits provide incentive for entrepreneurs to allocate resources towards their most productive uses and in ways that provide the most value to consumers.

 

• Producers lose incentives to produce when profit opportunities are restricted.

 

• The general standard of living for people in society tends to rise and fall relative to the level of restrictions placed on entrepreneurs’ ability to profit.

 

 

Additional Resources

Article: Windfall Profits by Robert G. Anderson (FEE.org)

"Among the charges most feared is the accusation that the firm has reaped windfall profits. While "normal" profits might be tolerated, anything above so-called normalcy is invariably subject to public charges of exploitation. The implication subtly drawn is that windfall profits accrue as a result of someone else’s losses. While the public might overlook small injustices, large profits are simply intolerable. This massive assault on profit-making reflects a belief that profits are something extra, the elimination of which would result in a general improvement in human welfare, that profits are gained at the expense of others—"unearned" and "unjust." This anti-profit mentality stems from a failure to understand the true nature and source of profits, the integral relationship existing between profits and losses, and their basic importance to the functioning of the market system."

 

Article: The Pursuit of Profit is Pro-Social by Matthew McCaffrey (FEE.org)

“In fact, that’s the beauty of free-market enterprise: it’s social whether it pursues an explicit social agenda or not. Critics of government intervention often point out that good intentions don’t equate to good policies. Likewise, the absence of good intentions doesn’t equate to bad policy, and lacking a specific social goal doesn’t make entrepreneurs antisocial. Think of Adam Smith’s observation about the butcher, brewer, and baker, which reveals that commerce is social because it’s mutually beneficial, not because entrepreneurs necessarily have a larger agenda.”

 

Podcast: Munger on Profits, Entrepreneurship, and Storytelling  (EconTalk, 60:04 min)

“Mike Munger of Duke University talks with EconTalk host Russ Roberts about profit. What is profit's role in allocating resources? How should we feel about the people who earn profits or who take them in ways that may not be earned? How easy is it to discover profitable opportunities? Munger examines these questions through a series of stories, real and fictional, to illuminate the sometimes puzzling nature of profit.”

 

Video:  (Learn Liberty, 54:26 min)

“Economics professor Howie Baetjer of Towson University explains how the market process generates improvements in the human condition. In particular, he highlights how profit & loss serve to help people channel their activities in creative and socially useful directions. Filmed at the 2006 IHS seminar "Exploring Liberty" at Princeton University.”