The Profit Motive

June 4, 2011

There’s actually a lot more wisdom than I sometimes think in the “folk” definition of the word “profit.” When discussing a possible policy change, people will often justify it by saying, “Yes, it will be costly to businesses, but the only real effect is that businesses will make lower profits. What’s so bad about that?”

Actually, this imaginary person seems to have a pretty good working definition of profit, except I think that what they mean is captured more precisely by the term “rent.” Generally, in economics, a rent is defined as payment to a resource owner above what would be necessary to keep that resource in its current use. In effect, this seems to be what most people have in mind when they’re talking about profits. A business will stay open as long as it’s “making a profit,” i.e. the payment is above what it costs to acquire and use all the necessary resources, so there wouldn’t seem to be any harm done by cutting those profits from $1 million to $1.

So far, we’re doing alright, but the idea I would like people to add to their understanding is that in the long run, profits are driven down to zero. It makes sense when you recognize that “long run” doesn’t refer to time per se, but rather just to the period when all options are open to people. A person who has already built a power plant will be making a profit on the power he sells to customers, because it costs less to operate the already-existing power plant than he can sell power for. The market price of electricity could drop a lot, all the way down to the cost of production, and he would keep operating the plant. The only thing is, in retrospect, he’d curse the bad investment he made by constructing the power plant in the first place. But that bad investment is in the past, the loss on that has happened, and there’s no reason to not operate the plant just because he wishes he had never invested in electricity generation.

On the other hand, people who own steel and all the other stuff you need to build a power plant haven’t committed their resources yet in any particular way. They have to decide whether the future profits from building a plant are enough to justify the initial investment. Another name for the “profits” that the plant owner makes, from this perspective, is “quasi-rent,” because they seem like profit from the perspective of owners of specialized resources (e.g. the constructed power plant). But people who haven’t invested yet have to take into account the cost of building a new plant, as well as the cost of running the plant after it’s built; they have to compare these costs to the income from operation.

Matt Yglesias and some other people want to say that a good way to deal with the rising cost of health care is to reduce the profits of medical care providers. We know, for example, that drugs cost pennies to produce while drug companies sell them for much higher prices. That means that drug companies are making a profit, and if those profits were reduced, they would keep on producing drugs all the same.

But what you have to recognize is that drug company profits aren’t some kind of closely-guarded secret. Everyone knows that drugs don’t cost much to make once you have already developed them. That means that investors have to make a decision: is it better to invest in creating a new drug, possibly to be rewarded later by “profits” on selling them, or should they invest in something else? The very last investor should be at the point where he expects to earn just enough in future profits to pay off his current investment. Change the profits, and investors are going to decide at a much lower level that investment is not worth the cost.

That’s why in the long run, it’s quite silly to argue that we can just cut spending on medical care without affecting the supply. Of course, current doctors are going to remain doctors, even if you cut their salary in half, because they can make more money as doctors than they can doing anything else. But the student deciding whether or not to enter medical school is looking at a very different situation. At present, the reward to being a doctor is just high enough so that the student on the margin is indifferent between that career and his next-best option. Cut the reward, and a lot of students are going to decide that it’s not worth the time and trouble to become a doctor. Think about what you would have to believe to believe that the number of students in medical school would be the same if doctors’ salaries were cut in half. I suspect you can’t possibly believe it.

So, don’t be fooled by “profits” that are really just current rewards for past investments. In the short term, if you cut those profits it’s not going to make much of a difference. Long term, though, it’s pretty much crazy to believe that you can cut spending and nothing else will have to change.


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