December 11, 2007

Homer: Second in line, and all I had to do was miss eight days of work.
Man: With the money you would have made working, you could have bought tickets from a scalper.
Homer: In theory, yes. [sotto voceJ jerk.
-The Simpsons, “Homer Loves Flanders”

[this post will be part of a multi-part series on capitalism]
I’ve recently come to the conclusion that much of the problem with the debate over capitalism is a matter of terminology. The word profit, for example, is sometimes seen as more significant than is truly warranted. Economists are talking about profits all the time. So are businessmen. Yet even between these two groups there is a huge gap in the meaning of the word profit.To a layman or businessman, profit means the difference between income and expenditures, both values measured in dollars. The virtue of this definition is that it is simple and profit, thus defined, is easily measurable.

To economists, profit is the difference between the total cost and total benefit of an activity. Importantly, total cost includes opportunity cost, and total benefit includes not just cash, but anything that provides utility (happiness).*

A simple illustration in which these definitions produce different measures of profit would be investment in money-market funds. Say you invest $100 in a money-market fund, earning 2% interest per year. In one year, you have $102, for a profit of $2.

However, it’s possible that investing in that fund was not the best possible use of your money. If the best possible use of your money would have been to invest in a 12-month CD at 5% interest, an economist would say you are not making a profit at all, but rather a loss of $3, the difference between what you could have made investing in the CD and what you did make investing in the money-market fund.
The choice of which definition to use involves a trade off. Profit in the business sense is simple and easy to calculate. However, as a result the notion of profit is basically arbitrary. Knowing, in an absolute sense, that I made $10 or lost $10 is meaningless. It only becomes meaningful when I know what my best alternative was. As an economic term, profit has real meaning, but for that it has to give up the simplicity it has in its business usage.

When economists talk about maximizing profit, that is completely different from maximizing the amount of cash you have. The tradeoff between labor and leisure is a good example. Economics does not recommend that you work a 24 hour day to “maximize profit”. That would be silly. A good model of the labor/leisure choice realizes that you get diminishing utility as you work more and more hours, just as you get diminishing utility from more hours of leisure. “Maximizing profit”, in this case, means finding your most preferred balance between time spent working and time spent not working.
Generally, maximizing profit is as simple as pursuing my most preferred option. Well, of course I’m going to do that! As long as I’m not ignoring some huge negative effect my choice has on other people, why shouldn’t I choose my most preferred option? An economist doesn’t presume that money will buy happiness; that’s a straw man. Economists only assume that rational actors will choose their most-preferred feasible option. Doesn’t that seem reasonable?

This post was boring and non-controversial, but that was the point. I will need it for more interesting posts in the future.

*This needs further discussion. Some economists try to measure happiness in an absolute sense using utils or some such term to mean units of utility. This is, however, widely acknowledge to be only a simple approximation, and thus ordinal measures the only true ranking possible. It is assumed that, as an economic actor, given a choice between any two things or scenarios A and B, I should be able to say that A is better than B, but not how much better one is than the other.


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