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.
Amen.
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.
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*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.
August 27th, 2009 at 12:32 pm
Thanks for the plug folks. I think we don’t disagree as I think what you say here is pretty much right on. You might find of interest a quote from the great South African economist W. H. Hutt who wrote “Profits are proof of social service.” That about sums it up for me.
August 27th, 2009 at 12:57 pm
Thanks for your original post and for dropping by. Sorry to give the impression of a disagreement (our quibble is more with the use of the phrase “profit motive” in general to describe what it is that motivates entrepreneurs.)
Love the quote by Hutt. He says in six words what it took us 1000 to say.
August 27th, 2009 at 1:02 pm
SBABG response to Steve’s article assumes that the ONLY thing driving people is the pursuit of a “better standard of living”. Perhaps that was misguided goal and is something that has contributed a great deal to where we find ourselves today.
“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.”
What indeed?
While America learns to want what they need and be grateful for what they receive it will go through a subtle but powerful paradigm shift. That shift or changing of a collective mindset will reveal the “What indeed?” No one knows.
What will motivate the future worker?
We are very close to having day to day survival be the sole motivating factor.
Motivational techniques of the past may not be applicable much longer.
August 27th, 2009 at 1:34 pm
“SBABG response to Steve’s article assumes that the ONLY thing driving people is the pursuit of a “better standard of living”.”
That’s not what we’re assuming at all. If anything we assume that individuals that that transact freely in a free market (trade goods and servies with other producers of those goods and services without coercion or compulsion) do so in order to improve their standard of living and in a free market the measure of their success in this endeavor can be measured by profit.
We’re not making any claims about what drives people to pursue their goals, only what drives entrepreneurs in a free market and what the consequences of that pursuit entail.
Now, that said, I think I understand what you are saying. But it’s semantic. Being motivated to survive and undertaking any means necessary to ensure it is a desire to improve your in the standard of *living* (death being the lowest standard). However, if you are surviving by force/theft, then there’s no transaction, and no “profit” (in fact, it’s a negative profit – lower living standard overall – b/c your “customer” [victim] isn’t willing to trade with you for the good you offer in “exchange.” or, maybe he is [your money or your life, sir!”]
August 27th, 2009 at 1:55 pm
This is an excellent point! Because liberals are naive and greedy, they think that profitability is the only end of capitalist economics. The truth is that businessmen know that profitability is a residual benefit of improved lifestyle, better health, happier society, etc. Without those benefits, profitability will be short-lived!
Profitability is directly related to social benefits! Take, for example, health insurance. The fundamental principle of health insurance is that the catastrophic cost of a serious health problem for one person can be made more manageable for a group! If the group pools their funds, the costs can be spread over a larger base provided the group does not all experience catastrophic health problems. The risk of the health problem, the size of the pool and the amount of the premium can be determined statistically. Changing the make-up of the pool changes the risk of the health problem occurrence and the cost of the premium.
Profit in the insurance industry is basically the variation between estimated payouts verses actual payouts. It is “statistics” that restrict pre-existing conditions from an insurance pool, not profits. Statistics determines premium costs and the health requirements of the policy, not only profits. Statistics cannot be ignored.
By bringing the government into the health insurance industry, politics will be brought into the statistical calculations the same way politics were brought into home loans for Fannie May and Freddie Mac! When that happens, either the premiums must go up or the coverage must go down. There is no other way, unless Obama figures a way to stop actuarial science the same way he tried to stop fiscal policy!!
August 27th, 2009 at 2:34 pm
Richard,
This is spot on. Today I had lunch with a guy who is not entirely sure how he leans on health care. He wants everyone to have coverage, and (prior to our lunch) thinks it’s wrong to deny people policies based on pre-existing conditions.
I pointed out to him that insurance is a great good because it helps us cover the *possible* though *improbable* cost of an event that likely will not occur at a price far less than the event will cost if it occurs. However, if an adverse event is instead *certain* or highly likely (rather than merely possible or probable), then the cost of covering that event is known.
Having a condition that will require certain, known expenditures, but expecting to pay less for your coverage than the known cost of your certain treatment, is like calling up a home insurer and asking for a policy while your house is on fire.
Then, he said, “So if insurance companies are forced to give policies to these people who have certain adverse health events, it will cost them a lot more money in coverage. Won’t the cost of that be spread out over the rest of the pool of insureds, making health insurance more expensive for the rest of us?”
And that, in a nutshell is big government at work. The beneficiaries of their programs and mandates are very visible (people with pre-existing conditions), but the victirms of their programs are frequently invisible, and only become apparent after the programs are put into place.
If you want to lower the cost of insurance and the ability for people with pre-existing conditions to get coverage, you lower the cost of health care. And you lower the cost of health care by unleashing the power of choice and competition.
And, hopefully, you personally commit to help those in need on a voluntary, not coerced, basis.
September 1st, 2009 at 8:16 am
“Because liberals are naive and greedy, they think that profitability is the only end of capitalist economics.”
I disagree with this statement. Even if you were not meaning to generalize an entire segement of the population, this statement is not relative to our current situation. Liberals are not evil, any more than conservatives are. And they are not controlling the federal government any more than the conservatives are, either.
I’m growing very weary of Obama being labeled socialist and communist by folks who thought that W. was so wonderful. The problems we are facing right now, especially where the economy is concerned, are the result of 100 years of quiet manipulation by political party leadership.
When we recently had our income tax withholdings reduced as a stimulus (joke) measure, I heard everybody whining about how they’ll still have to pay the same rate when they file at the end of the year. I didn’t hear these folks comlaining about the stimulus (jokes) checks they got from W. (twice), that were added into our income at the end of the year for tax calculations. Although this didn’t affect my federal tax very much, it more than doubled my state income tax liability, somehow.
Obama is no more socialist than W. was. What Obama is; and what W., Clinton, Bush Sr., and Ronnie “Ray-gun” were; is a corporate puppet, chosen by the party leadership’s financial backers, and forced upon us by unfairly limiting access to the electoral process through organizations like the Commission on Presidential Debates. I dare to say out loud that I think that Carter was the last party puppet to have enough scruples to filter which corporate ideals he was willing to be a puppet for, instead of just accepting whatever hand was holding the money at any given time.
And, lest there be any confusion, when I say “party”, I’m referring to the one party that is trying to perpetuate the illusion that Democrats and Republicans are somehow different on a fundamental level.
It started when the Federal Reserve was given the power to print our currency, and it’s been slowly getting worse ever since as the federal government does more to prop up failing big businesses and monopolies, in the twisted interest of supporting capitalism without a free market aspect. As I see it, if the stranglehold that large corporations have been able to establish on our government isn’t broken soon, socialism will look pretty damn good compared to the nation-wide mining town we’ll be living in. Think back to the early 1900s, when someone would work for a mining company and live in the company owned housing, and get paid in company notes that were only good at the company store. There was never enough money in the company notes to cover your needs, but that was ok because the company store would extend your line of credit. But if you quit your job, you had to pay it back, with interest. This was engineered indentured servitude, and it was done on purpose.
Our federal government is supposed to be acting in the best interests of “We the people,” and I do not consider any corporation (large, small, anything) to be entitled to the same protections and priviledges that I am as a citizen.
August 27th, 2009 at 6:46 pm
For profit enterprises are terribly evil. Not only do they generate profits but they actually try to return the money invested to those that provided it.
Even worse, such endeavors have to create a product or service that people are willing to pay for. And this might be something completely new that disrupts the five year plans of the politburo.
It gets worse. Many of these companies give employees stock options. This good people away from work that provides thing no one will pay money for. And these are the very projects we need to dispose of the annoying capital.
Fortunately, the government is effectively starving these for-profit thingies by sucking up all of the available credit.
And this is the gift that keeps on giving, as it raises the public and permanently raises our ability to remove resources that people would normally use to invest in the for-profit things.
September 1st, 2009 at 8:18 am
“Fortunately, the government is effectively starving these for-profit thingies by sucking up all of the available credit. ”
Again, I disagree. They are starving anyone that isn’t able to come up with enough money to pay for favorable legistlation…
August 31st, 2009 at 3:44 am
Maybe we could create a simple computer simulation game to demonstrate to a wider public the excellent points made here. Any programmers around?
I have an idea for a simple set of rules with just 2 parameters – a scale from selfish to sucker and a scale from honest to crooked. Selfish always seeks best value and does due diligence, never deals with one he knows to be crooked. Sucker always listens to “expert” advice and expects the gov’t to “protect” him. Honest always delivers on a promise, crooked takes your money and runs.
The object is to survive – stay in the game – and increase standard of living.
My prediction is the combination selfish and honest wins hands down.