Capitalism’s Visible Hand: The Uniformity of Profit Principle

by | Jul 17, 2022

The best way to begin to understand the functioning of the price system, and thus the full nature of the dependence of the division of labor on capitalism, is by understanding the following very simple and fundamental principle. Namely, there is a tendency in a free market toward the establishment of a uniform rate of profit on capital invested in all the different branches of industry.

The dependence of the division of labor on the price system centers on the coordinating function of prices.

The price system coordinates the various branches of the division of labor in a variety of essential respects.

  • It keeps the various branches of industry, and thus the production of the various products, in proper balance with one another by appropriately adjusting their relative size.
  • It does the same with respect to the relative size of the various occupations.
  • It also achieves a harmonious balancing of the supplies of the various products produced with respect to their distribution in terms of place and time.

These results are accomplished by the operation of a series of principles that I call uniformity principles, which are described and elaborated in Capitalism: A Treatise on Economics.

The tendency in a free market toward the establishment of a uniform rate of profit

The best way to begin to understand the functioning of the price system, and thus the full nature of the dependence of the division of labor on capitalism, is by understanding the following very simple and fundamental principle. Namely, there is a tendency in a free market toward the establishment of a uniform rate of profit on capital invested in all the different branches of industry. In other words, there is a tendency for capital invested to yield the same percentage rate of profit whether it is invested in the steel industry, the oil industry, the shoe business, or wherever.

Profit, of course, is the difference between sales revenues and costs. The rate of profit on capital invested is the amount of profit divided by the amount of capital invested. [1]

The reason for the tendency toward a uniform rate of profit on capital invested is that other things being equal, investors naturally prefer to earn a higher rate of profit on their capital rather than a lower one. The higher the rate of profit they earn, the larger the amount of profit they earn per year, and thus the more rapidly they can augment their wealth through saving and, at the same time, the more they can afford to consume. As a result, wherever the rate of profit is higher, and all other things are equal, investors tend to invest additional capital. And where it is lower, they tend to withdraw capital they have previously invested.

The influx of additional capital in any initially more profitable industry, however, tends to reduce the rate of profit in that industry. This is because its effect is to increase the industry’s production and thus drive down the selling prices of its products. As the selling prices of its products are driven down, closer to its costs of production, the rate of profit earned by the industry necessarily tends to fall.

Conversely, the withdrawal of capital from an initially less profitable industry tends to raise the rate of profit in that industry, because less capital means less production, higher selling prices on the reduced supply, and thus a higher rate of profit on the capital that remains invested in the industry.

To illustrate this process, let us assume that initially, the computer industry is unusually profitable, while the motion-picture industry is earning a very low rate of profit or incurring actual losses. In such conditions, people will obviously want to invest in the computer industry and to reduce their investments in the motion-picture industry.

As investment in the computer industry is stepped up, the output of computers will be expanded. In order to find buyers for the larger supply of computers, their price will have to be reduced. Thus, the price of computers will fall and, as a result, the rate of profit earned in producing them will fall.

On the other hand, as capital is withdrawn from the motion-picture industry, the output of that industry will be cut, and the reduced supply it offers will be able to be sold at higher prices, thereby raising the rate of profit on the investments that remain in the industry.

In just this way, initially higher rates of profit are brought down and initially lower rates of profit are raised up. The logical stopping point is a uniform rate of profit in all the various industries.

***

This principle of the tendency of the rate of profit toward uniformity is what explains the amazing order and harmony that exists in production in a free market. It was largely the operation of this principle that Adam Smith had in mind when he employed the unfortunate metaphor that a free economy works as though it were guided by an invisible hand.

I will discuss this topic further in the next article in this series.

Notes

[1] The rate of profit on capital invested should not be confused with the concept of profit margin. A profit margin is a profit taken as a percentage of sales revenues, not capital invested. Because of technical factors centering on the periods of time which must elapse between outlays of capital and receipts of sales revenue, different industries tend to earn permanently unequal profit margins, even though they tend to earn equal rates of profit on capital invested.

Thus, for example, a retail grocery business, which has a substantial portion of its capital invested in merchandise of the kind that is sold within days of purchase, or even on the very same day, may have annual sales revenues equal to five times its capital. A steel mill, on the other hand, very different profit margins must exist if equal rates of profit on capital invested are to exist. An electric utility may have annual sales revenues that are equal to only half of its capital.

Because of these very different rates of capital turnover—i.e., the ratio of sales to capital—namely 5:1, 1:1, and 1/2:1, very different profit margins must exist if equal rates of profit on capital invested are to exist. Thus, the profit margin in the retail grocery business would have to be just 2 percent; that of the steel mill, 10 percent; and that of the electric utility, 20 percent, in order for all of them to earn a rate of profit on capital invested of 10 percent.

 

This series is adapted from Reisman’s Capitalism: A Treatise on Economics, Chapter 6, The Dependence of the Division of Labor on Capitalism, “The Uniformity-of-Profit Principle and Its Applications.”

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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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