A Sticky Misunderstanding

Critics of free markets often claim that one of the major shortcomings of an unrestricted market is that companies “extort” large profits, to the detriment of consumers. Underlying this claim is the assumption that companies should not be making profits; that a no profit situation would be more desirable. Perhaps the “Perfect Competition” model of a market contributes to this fallacy, because in this ideal state companies don’t make economic* profits. In this model, the price of a good equals the cost of producing the good, including opportunity cost-the profits forgone by not pursuing the next best use of resources. So a firm can make an accounting profit (bringing in more money than you pay out, and what is generally meant by the term “profits”) and still have no economic profits. The critical part of this picture is the opportunity cost, because it cannot be calculated and it is the difference between accounting and economic profits.

Labor and material costs are easy to measure, but by selling tables, a firm forfeits the chance to make dressers, or ships, or thousands of other things. How costly is that sacrifice? Only the decision maker of the firm can guess for himself what the forgone benefits could be. The extra compensation for making tables (beyond the obvious costs) is an inducement for a company to make tables instead of one of the other possibilities. If there were no profits, a company could not know how best to use their resources. These profits are signals to alert people that there is more need for one good than another. When lawn flamingos become more highly desired, the price rises. This economic profit opportunity attracts more companies to provide that good. Therefore, some compensation above cost of production is a reward for a firm “closing the gap” between what people want and what producers are making.

So here is the catch: The opportunity cost of making one thing over another can’t be calculated, and it is different for each firm. The Perfect Competition model glosses over this complexity and simply bundles a place-holding “opportunity cost” with the other costs. This model assumes no economic profitsbecause any money firms make beyond costs is reimbursement for forgone opportunities.  (This can be assumed because if there was a better use of a company’s resources, they would be pursuing that action instead.)

Non-economists can easily assume that “no economic profits”= no profits (in the general understanding of the term). Those who say that profits are higher than necessary (Occupiers, among others), don’t realize that economic profits only exist for very short periods because if the money to be made is one industry is so much higher than in another, firms will move to that industry. Prices will fall, and profits will eventually even out between industries. (In theory.) But the weird thing is, even if we accept the idea that accounting profits are not a big deal and economic profits are the real profits, we miss the point that economic profits drive innovation. Yes, it is true that businesses that make economic profits are raking in the moolah. But they earn that extra moolah by meeting the needs of customers.

*Key: Accounting profits: The money left over after all expenses are paid; general understanding of the term “profits”.

Economic profits: Accounting profits minus opportunity cost (the potential gains you give up by taking one course of action rather than another). Because we can only guess what we are giving up, and because it does not fit into a tidy equation, opportunity cost is too often ignored. *sigh* Theoretically, economic profits won’t last long, because they are a signal that it is more advantageous to make one item over another. So more companies will shift to making the higher valued item, and the price will fall until the economic profit is gone.

A special thank-you to Dr. Ivan Pongracic, Mises Chair of Hillsdale College’s Economics Department and my Industrial Organization professor, for inspiring this post and generously proofreading the draft.