The Role of Profits in the Economy

by | Jul 14, 2002

Profits are misunderstood, seen as unearned and sometimes condemned as evil. Maybe that’s why people often reverently pronounce, with an air of moral superiority, “We’re a nonprofit organization.” Before people mount their moral high horse, they should remember that nonprofit organizations have caused some of the world’s greatest evil, heartache and dissatisfaction. After all, among […]

Profits are misunderstood, seen as unearned and sometimes condemned as evil. Maybe that’s why people often reverently pronounce, with an air of moral superiority, “We’re a nonprofit organization.”

Before people mount their moral high horse, they should remember that nonprofit organizations have caused some of the world’s greatest evil, heartache and dissatisfaction. After all, among nonprofit organizations are: oppressive governments, postal services and public education.

Profits are not a large item in national income accounts. In 1999, after-tax profits accounted for about 6 percent of gross domestic product (GDP) compared to wages, which accounted for over 60 percent. Profits — like wages, interest and rent — are a vital component of a smoothly operating economy.

So what are profits? Put simply, profits are a price, just as wages, rents and interest are prices. Profits are the prices paid as residual claims to entrepreneurs in their role as risk-takers, innovators and decision-makers. Just as workers will not provide their services without wages, entrepreneurs will not provide theirs without profits. Profits, like other prices, steer resources from low-valued uses to higher-valued uses.

A successful businessman must take in enough revenue not only to cover wages, rents and interest, but profits as well. In order to accomplish that feat, he must not only please customers but he must do it in a manner that efficiently utilizes all of his resources. If he fails to cover all of his costs, it means that he’s not using his resources efficiently and-or consumers don’t value his output relative to some other alternative.

When a firm cannot turn a profit, it goes out of business. That means its resources, workers, building and capital become available to someone else who might put them to a better use. Of course, government can thwart this process with subsidies that enable entrepreneurs to continue to mismanage resources.

You say, “OK, Williams, I’m with you on normal profits, but what about windfall profits — what some people call obscene profits?” Windfall profits are indeed profits far beyond what’s necessary for an entrepreneur to stay in business, but windfall profits also play a vital role. Windfall profits signal that a human want is not being met. Resources emerge to meet that want. For example, when Hurricane Andrew devastated parts of South Florida, plywood prices skyrocketed. Florida’s attorney general threatened actions against companies for price-gouging.

Those windfall profits conveyed messages to the rest of the economy. Let’s say that pre-hurricane plywood prices were $10 a sheet and afterward they were $20. That profit potential created a powerful signal. Instead of plywood manufacturers selling their plywood inventory to, say, Pennsylvania wholesalers for $8 a sheet, they were more than happy to ship them to Floridian wholesalers for higher prices. Wholesalers in other states were happy to sell their plywood to Floridians for higher prices. Since plywood supplies were moving to Florida, plywood prices elsewhere rose.

From a social point of view, this is wonderful. Say I planned to spend a Saturday afternoon building a house for my dog. I go to my neighborhood lumberyard in Pennsylvania expecting to pay $10 for a plywood sheet, and get there and find out it’s $18. I say, “The heck with the dog; let him sleep in the rain!” I have voluntarily made a plywood sheet available for a more valuable use — rebuilding the house of a human.

None of these and other voluntary actions making plywood available to Floridians would happen if price controls were slapped on plywood making the pre- and post-hurricane prices the same. Freely fluctuating prices, including the potential for windfall profits, encourage people to do voluntarily what’s in the social interest.

In free and open markets, profits are to be praised — not scorned, as economic and political charlatans would have us do.

Walter Williams (March 31, 1936 – December 1, 2020) was an American economist, commentator, academic, and columnist at Capitalism Magazine. He was the John M. Olin Distinguished Professor of Economics at George Mason University, and a syndicated editorialist for Creator's Syndicate. He is author of Race and Economics: How Much Can Be Blamed on Discrimination?, and numerous other works.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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