Capitalism’s Visible Hand: How Profit Allocates Capital Across Industries

by | Jul 20, 2022

The uniformity-of-profit principle explains how the activities of all the separate business enterprises are harmoniously coordinated so that capital is not invested excessively in the production of some items while leaving the production of other items unprovided for.

In the United States production is carried on by several million independent business enterprises, each of which is concerned with nothing but its own profit. Knowing this, and knowing nothing about economics, one might easily be led to think of such conditions as an “anarchy of production,” which is how Karl Marx described them. One might easily be led to expect that because production was in the hands of a mass of independent, self-interested producers, the market would randomly be flooded with some items, while people perished from a lack of others, as a result of the discoordination of the producers. This, of course, is the image conjured up by those who advocate government “planning.” It is the view of most advocates of socialism.

The uniformity-of-profit principle explains how the activities of all the separate business enterprises are harmoniously coordinated so that capital is not invested excessively in the production of some items while leaving the production of other items unprovided for. The operation of the uniformity-of-profit principle is what keeps the production of all the different items directly or indirectly necessary to our survival in proper balance. It counteracts and prevents mistakes leading to the relative overproduction of some things and the relative underproduction of others.

To understand this point, assume that businessmen make a mistake. They invest too much capital in producing refrigerators and not enough capital in producing television sets, say. Because of the uniformity-of-profit principle, the mistake is necessarily self-correcting and self-limiting. The reason is that the effect of the overinvestment in refrigerator production is to depress profits in the refrigerator industry, because the excessive quantity of refrigerators that can be produced can be sold only at prices that are low in relation to costs. By the same token, the effect of the underinvestment in television set production is to raise profits in the television set industry, because the deficient quantity of television sets that can be produced can be sold at prices that are high in relation to costs. The very consequence of the mistake, therefore, is to create incentives for its correction: The low profits— or losses, if the overinvestment is serious enough— of the refrigerator industry act as an incentive to the withdrawal of capital from it, while the high profits of the television set industry act as an incentive to the investment of additional capital in it.

Moreover, the consequence of the mistake is not only to create incentives for its correction, but simultaneously, to provide the means for its correction: The high profits of the television set industry are not only an incentive to investment in it, but are themselves a source of investment, because those high profits can themselves be plowed back into the industry. By the same token, to the extent that the refrigerator industry suffers losses or earns a rate of profit that is too low to cover the dividends its owners need to live on, its capital directly and immediately shrinks, and it is thereby made unable to continue producing on the same scale.

In this way, the mistakes made in the relative production of the various goods in a free market are self-correcting. With good reason, the operation of profit and loss in guiding the increase and decrease in investment and production has been compared to an automatic governor on a machine or to a thermostat on a boiler. As investment and production go too far in one direction, and not far enough in another direction, the very mistake itself sets in motion counteracting forces of correction. Moreover, the greater the mistake that is made, the more powerful are the corrective forces. For the greater the overinvestment and overproduction, the greater the losses; and the greater the underinvestment and underproduction, the greater the profits. Thus the greater the incentives and the means (or loss of means) to bring about the correction. In this way, the mistakes made in a free market are not only self-correcting, but self-limiting as well: the bigger the mistake, the harder it is to make it.

Further, in a free market, most of the mistakes that might be made in determining the relative size of the various industries and the relative production of the various goods are not made in the first place. This is because the prospect of profit or loss causes businessmen to weigh investment decisions very carefully in advance and thus to avoid mistakes as far as possible from the very beginning. In seeking to avoid losses, businessmen necessarily aim at avoiding overinvestment and overproduction. In seeking to make the highest possible profits, they necessarily aim at providing the market with those goods in whose production they do not expect other businessmen to invest enough. This last fact, incidentally, makes each businessman eager to invest sufficiently in his own industry, lest the opportunities he does not seize be seized by others instead.

In addition, the free market performs a constant process of selection with respect to the ownership of capital. Capital gravitates, as it were, to those businessmen who know best how to employ it and is taken away from those who do not know how to employ it. For those who invest in providing goods that are relatively more in demand make high profits and are thereby able to increase their capital, and, consequently, their influence over future production; while those who invest in producing goods that are relatively less in demand earn low profits or suffer losses, and are correspondingly deprived of capital and of influence over future production. At any given time, therefore, capital in a free market is mainly in the hands of those who are best qualified to use it, as demonstrated by their past performance in investing. For this reason, too, most of the mistakes that might be made in determining the relative production of the various goods are avoided in the first place in a free market.

This series is adapted from Reisman’s Capitalism: A Treatise on Economics, Chapter 6, The Dependence of the Division of Labor on Capitalism, “Keeping the Various Branches of Industry in Proper Balance.”

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George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics. See his Amazon.com author's page for additional titles by him. Visit his website capitalism.net and his blog atGeorgeReismansBlog.blogspot.com. Watch his YouTube videos and follow @GGReisman on Twitter.

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