Steven Horwitz recently wrote a lucid and pithy piece for The Freeman called Profit: Not Just a Motive that you must read. It is particularly timely because Big Government proponents have, as of late, been railing on “for-profit” institutions, attacking the “profit motive” and claiming that profit-seeking leads to delivery of poor service (of all things!). Horowitz eviscerates these arguments. His conclusion:
[The] real problem with focusing on the profit motive is that it assumes that the primary role of profits is to motivate (or in contemporary language “incentivize”) producers. If one takes that view, it might seem relatively easy to find other ways to motivate them or to design a new system where production is taken over by the state. However, if the more important role of profits is to communicate knowledge about the efficiency of resource use and enable producers to learn what they are doing well or poorly, the argument becomes much more complicated. Now the critics must explain what in the absence of profits will tell producers what they should and should not do. Eliminating profit-seeking from an industry doesn’t just require that a new incentive be found but that a new way of learning be developed as well. Profit is not just a motive; it is also integral to the irreplaceable social learning process of the market. Critics may consider eliminating the profit motive the equivalent of giving the Tin Man from Oz a heart; in fact it’s much more like Oedipus’ gouging out his own eyes.
However, we do have one quibble.* We believe that “profit motive” is a misnomer and it is mistaken to assume that profit is a motive. This goes back to wanting to be very careful in the words we allow the government to use to describe our activities.
We’d argue that “profit” is not a motive, but a signal or measurement of how well we’re pursuing a true motive.
The true motive in all productive undertaking by individuals is the acquisition of a higher and better standard of living. Profit (in a free-market) is the signal to a provider that she is both delivering to others, and achieving for herself, a higher living standard.
So let’s call it by the more accurate “improved standard of living motive”
The “spread” between the cost (to you) of a service you provide and the price paid you is a measure of how well you are adding value in the world. If it were a mathematical formula, it would be expressed:
Price customer pays for good in free market – cost to you to provide the good = Measure of how well you are improving living standards for yourself and others
When people are willing to pay higher prices for the goods or services you are delivering, it is a sign that they are voluntarily giving up a good they have in their possession for another good you can provide them, because they believe they will be better off and have a better standard of living. If you fail to provide them with that promise, they will not trade with you. Rising price (again, in the presence of free markets and also the absence of inflation) is a sign that you are increasingly providing goods people believe will improve their standard of living.
Now, the lower your costs are for the services you provide, the more efficiently and less wastefully you are providing the service. Cost, relative to price, indicates how well you conserve scarce resources, how well you use and allocate scarce resource. That is, your ability to lower your costs of production relative to your prices is a signal that you are utilizing resources well.
Those that utilize resource well have more profit. They then are rewarded with growth options through reinvestment of those profits. This is good. Those that provide more value while using less resource should be rewarded, should be the ones providing more of this good or service to others.
More profit is not only reinvest-able, but also can be extracted from the business and spent for consumption purpose elsewhere (improving the entrepreneur’s standard of living and allowing others to improve theirs through the trade of their particular good or service).
Notice that competitors are now motivated to emulate the best practices of the best providers – increasing value delivered while simultaneously using resources more efficiently and less wastefully.
If the spread between cost and price is widening (another way of saying profits are increasing), it is a sign that the standard of living is increasing for everyone – both you and others. You are using less units of a scarce resource to provide an ever-more-valuable-and-useful good to others.
Absent a free market, profits may be passing along distorted information and may not be a sign that standards of living are improving for others, but in a free market profit is a feedback mechanism that confirms to you that you are engaging in right action and maximizing the standard of living for yourself and others.
*Our quibble is not with Prof. Horowitz so much as it is with the use of the phrase “profit motive” in general to describe what it is that motivates entrepreneurs.