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Profit-MakerFriend or Foe?

APRIL 01, 1985 by HOWARD BAETJER JR.

Howard Baetjer Jr. is a member of the staff of The Foundation for Economic Education, primarily responsible for taking FEE’s message to schools and colleges.

Is one who makes profits an exploiter, as is so often claimed? Or is that person a social benefactor? Do profits arise from harming others or making them better off?. Do profit-makers deserve resentment or gratitude? To examine this question, we will need to look at opposing eco nomic theories of value and profits. But before that, we had better be clear about the nature of wealth, what it is and how it comes to be.

What is wealth, precisely? Is money wealth? Suppose you could wave a magic wand, and become owner of millions of dollars, billions of marks, trillions of yen, and gold and silver coins by the truckload. Would that be sufficient to make you wealthy?

Suppose that as you waved that magic wand, you found yourself, with all that money, on the very spot you now occupy, in 1585. If you are in North America, there would be nothing in sight but the rocks and trees and grasses and streams, and maybe a stray Indian.

You would be a trillionaire, but would you be as wealthy as you are at this moment, no matter how meager your bank account might be? No. Real wealth is not money. Wealth in the strictest sense is valuable things—things we can use to support and enrich our lives. It is goods and services: food, clothing, shelter, electric light, symphony orchestras, diesel engines, milkshakes and so on. That is the first point: wealth is valuable goods and services.

For the second point, how does wealth come to be? Does it shower down like manna from heaven, or grow out of the ground all ready for our use? Do houses spring up from the earth and furnish themselves for us; do big jetliners lay eggs from which hatch little jets? No. These things have to be created; they have to be built; they have to be brought into existence by the ingenuity and labor of people. That’s the second point. Wealth is created by people.

But, out of what do people create this wealth—with what do they build it? Do they snap their fingers or wave a magic wand, and produce it from nothing? No. They build it out of what is already here. To take a phrase from my colleague Bettina Greaves, we have progressed from caves to computers simply by moving things around—most thoughtfully and exactly, to be sure—but just by moving things around. The clay, iron and other substances that compose buildings have existed as long as the earth has, but they are more usefully arranged now into cinder-blocks and steel beams. The electrons going through fluorescent lamps were here, too, but not arranged in that clever combination with glass tubes and vapor so as to make light. What makes wealth of raw substances is the value of their arrangement. The third point, then, is that people create wealth by cleverly rearranging and recombining the natural things that make up the earth.

To sum up, wealth is valuable goods and services, which ingenious people create, by rearranging and recombining the physical stuff of the earth. The last part of this is most significant: wealth comes to be when somebody discovers and produces a better, more valuable arrangement of things.

What Determines Value?

We can accept the above proposition that wealth is essentially a valuable arrangement of things, but that invites the question: What makes something valuable? Why are some things wealth and other things worthless? Why do Cadillacs cost more than matchbox toys, sirloin steak more than hamburger, tickets to see Michael Jackson more than tickets to see the Chicago Sym phony? What determines value?

This is a fundamental question, on the right and wrong answers to which are built right and wrong theories of profits, and entirely different answers to our main question about whether the profit-maker is an exploiter or a benefactor. We begin with the generally accepted theory, which also happens to be wrong.

Labor?

One of the greatest economists ever, Adam Smith, misunderstood value, and thereby started a long chain of confusion. Smith was a proponent of the labor theory of value, which holds in essence that the value of a thing is determined by the amount of labor that went into making it. To quote from The Wealth of Nations, “Labour, therefore, is the real measure of the exchangeable value of all commodities.” Notwithstanding the brilliance of most of Smith’s other ideas, this is an error.

Karl Marx picked up Smith’s error and added more mistakes on top of it to produce his theory of profit. He argued that since the value of a thing is determined by the labor that went into it, laborers—and laborers only—are responsible for the thing’s value.

If you are a worker on a ranch, for example, and you fertilize a field, plant alfalfa seed, irrigate it, cut the ripe alfalfa, bale it and stack it up for delivery; you, the laborer, are responsible for transforming the alfalfa seed and other raw materials into, say, $1000 worth of feed for cattle. Suppose the raw materials—the fertilizer and seed, the gasoline for the cutters and balers, the baling wire and the like—cost the owner of the ranch, your employer, $400. The “labor value” Marx says you added, then, is $600.

But all you get for your work is your wages, say, $500. This leaves your employer a hefty profit of $100. But he didn’t labor at all; how is it that he has extra money? According to Marx’s theory, this profit for your employer is “surplus value,” the labor value you put into the hay, that he didn’t pay you for. You did $600 worth of work, but only got paid $500. You deserve all $600. Your employer has appropriated from you—stolen from you—$100 worth of the product of your labor.

To move on to the third part of this foolish but widely believed theory, in this way employers “exploit” their workers. Your employer takes his profit, the “surplus value” of your labor, at your expense. It was created by you; therefore it rightly belongs to you, according to this theory. The very fact of profit, then, shows there has been exploitation.

The “Zero-Sum” Idea

This whole ideological package—the labor theory of value, profits as surplus labor value, and the exploitation of working for wages—depends on and illustrates another fair-sounding but wrong idea, the zero-sum view of the world. This is the idea that if somebody profits, somebody else must be harmed, because after all there is only a certain amount to go around. If we add up, or sum the changes in economic condition of everybody, we must always come out to zero, because one person can gain only what another loses. Business activity simply shifts around existing wealth. That’s the zero-sum view.

Those who believe in the labor theory of value—who hold the zero-sum view of life—necessarily see the profit-maker as an exploiter. This includes not just Marxists, but also milder leftists. A congressman, for example, once criticized the oil companies for making “obscene profits.” And, sad to say, many men and women in business somehow think all this is true. They want to make profits, of course, and they strive very hard to make them. But they feel guilty about it. They worry that they are profiting at the expense of others, that in truth, they are exploiters—vicious capitalists who prey on their fellows.

This worry shows how very powerful error can be, because it just isn’t so.

The Subjective Theory of Value

Though the labor theory has a certain plausibility, we can see that it is false by a simple example. Suppose the amount of work that went into making a commodity did determine its value. Then suppose that on neighboring ranches, two different crops are produced, each requiring and getting the same amount of labor. Suppose one ranch raises alfalfa, and the other raises poison ivy. If the labor theory of value were true, the two crops would have to be worth the same!

But obviously they are not worth the same. People will pay much more for hay, which nourishes cattle, than for poison ivy, which makes people itch. And therein lies the key to the true theory of value. People’s personal preferences determine value and price. They will pay more for what they want more. The true theory of value is a subjective theory of value. Value exists not in the thing valued, but in the minds of the valuers.

This subjective theory of value is a critically important economic concept, one of the crucial insights on which the so-called “Austrian” school of economics is based. It was discovered by three economists, Carl Menger, Stanley Jevons, and Leon Walras, all working independently, at just about the same time—the early 1870s. With it they cleared away Adam Smith’s labor theory error, and opened up the way to a proper understanding of profits.

Once the labor theory of value goes, of course, the Marxian theory of profits immediately goes with it. Since there is no such thing as “labor value,” then clearly the Marxian notion of profits as “surplus labor value” is false.

An accurate view of profits is built on two implications of the “Austrian” subjective value theory. The first is this: a certain thing does not have one value for all people in all different times and situations. Values are different for different people, and they change all the time. (I might add that in speaking of values as subjective I do not mean moral values such as courage and honesty, which are always fundamentally valuable in their way, but only personal valuations of marketable goods.)

Values change and vary. This is crucial. The same thing can have different values for the same person in different times and situations, and it can have different values for different people at the same time and in the same situation. For example, right after you have eaten a full meal, you probably would not pay much for a large milkshake. But as time goes by you start to get hungry again, and gradually the price you would pay for a milkshake increases. If you have to go without food for a long time, especially in hot weather, you might eventually be willing to pay five or six dollars for a milkshake. Its value for you changes with your situation.

When Trade Is Voluntary Both Parties Benefit

This obvious truism, that values vary and change, leads in turn to a second important insight: When an exchange is made in a free setting, both parties to the exchange benefit. The things exchanged are not of equal value, as has so often been thought, but of different value—to the people exchanging. Indeed, that is why they make the exchange. Consider yourself, for example, when you do business with a milkshake vendor. The value you put on the milkshake in your situation is greater than that of the people selling it. You value the milkshake more than the money; they value the money more than the milkshake. Otherwise there would be no exchange at all. You give up your money; they give up the milkshake. Both parties say thank you; both parties are happy; both have benefited.

The situation is similar where the exchange is not of ice cream for money, but of labor for money. Consider those of us who worked as summer laborers on a Nevada ranch harvesting alfalfa. We drove the machines, built fences, painted storage tanks and so on, earning slightly over minimum wage. When we took those jobs, offering the ranch owner our work in exchange for his money, we valued the money he gave us more than the time and labor we gave him, and he valued our work more than the money he gave us. There was benefit on both sides.

Marx’s exploitation theory thus reverses the truth. Workers are not exploited by their employers. On the contrary, in a free exchange they are benefited by their employers—and vice versa. That’s the nature of free exchange. True, we might have wished that our efforts were worth more—that we could have commanded a higher wage—but in our particular situation in that time and place, that job at that wage was better than any other available use of our time and effort.

Free Exchange Is Positive Sum

In a free exchange, both parties benefit. Note that this fact disproves the zero-sum assumption of economic life. In a free-market exchange, neither party loses for the benefit of the other; both parties benefit, or they would not exchange at all. Free exchange in a market setting is not a zero- sum game, but a positive sum game.

While we’re on it, let’s make another point about this zero-sum idea. Those who believe it often remind us that resources are finite: they imply by this that therefore wealth is finite. True, resources are finite, if by resources they mean only raw materials. But the ultimate resource, as Julian Simon has pointed out in a book by that name, is people—human ingenuity and creativity. Of that resource there seems to be no limit at all. Human beings are astonishingly ingenious, creative creatures. They have a seemingly unbounded capacity to figure out better arrangements for these finite raw materials.

And for this reason, the finiteness of physical resources does not put any bounds on wealth. Wealth, as we saw at the outset, is not in substances, but in their arrangement. With the same physical substances, creative people can increase the amount of wealth until the crack of doom, through ever-better arrangements of those substances.

Profits

To understand fully what profits are and how they are made, we need to add one more concept to those we have already observed. We have seen that people create wealth by favorably rearranging and recombining physical things, and that different people place different values on things. To these concepts we add one more thought: our knowledge is imperfect. Most importantly, we have very imperfect knowledge about the most valuable ways to arrange and combine things. Often we do not know of mutually beneficial exchanges we might make with others. Or, knowing of exchanges we would like to make, often we don’t know how to manage them inexpensively enough. And nobody knows of valuable products and methods that have not yet been discovered.

With these three concepts we can define profits. Profits are what result from somebody’s overcoming imperfections of knowledge, discovering and producing a more valuable arrangement of things. Put another way, profits are a person’s reward for increasing value, for increasing wealth. Remember that wealth is in the arrangement, not in the substances: he or she increases wealth who comes up with a more valuable arrangement.

Let’s illustrate this with an example. Suppose Mr. Phelps, the owner of the ranch where I worked, has a number of big stacks of hay that he would like to sell. In that situation, Mr. Phelps puts a relatively low value on hay. Let’s suppose he would take as little as five dollars a bale for it. His knowledge is imperfect. He knows that there are lots of dairy farmers in California and New Mexico and Nevada who would like to buy his hay, but he does not know exactly who they are, how much they need, or what they would pay for it. Furthermore, he does not know where to get trucks and drivers to ship his hay. At the same time there are lots of dairy farmers who put a relatively high value on hay. They would be glad to pay up to six dollars a bale for it. They know there are ranchers with hay to sell, but they aren’t sure where those ranchers are, or how much they can deliver. And they don’t know where to get trucks and drivers either. This is a problem for both Mr. Phelps, who has the hay, and the dairy farmers, who need it.

These folks are in a situation where they might make a mutually beneficial exchange, but they can’t manage it. What they need now is for somebody to discover this unfavorable arrangement, figure out how to fix it, and do so. They will be glad to reward someone who does.

At the same time there are people leasing eighteen-wheeled flatbed trucks that might be used to ship hay, but they don’t know about Phelps and the dairy farmers. And there are oil distributors, selling diesel fuel that could run those trucks from Nevada to California, but they don’t even know what alfalfa is. And there are truck drivers who would like to make the run, if somebody told them where to go, and offered them a better deal doing that than something else.

All the potential is there for half a dozen mutually desirable exchanges. But so far, nothing happens. The hay sits in the lot, the dairy farmers fret, and the trucks, the gas, and the drivers are being used to deliver things less important than that wonderful, high-protein hay. All these resources need somebody to coordinate them properly, to rearrange and recombine them into greater wealth than they make up in their present arrangement. What is needed is an entrepreneur.

The Role of the Entrepreneur

Along comes the hay broker. He leases the eighteen-wheeled trucks, buys the diesel fuel, and hires the drivers, giving each one directions to Mr. Phelps’ Ranch and from there to the dairies. He negotiates with Mr. Phelps to buy hay at, say, $5.25 a bale, and with the dairy farmers to sell it at, say, $5.75 a bale.

Now, is Mr. Phelps better off?. Yes, he has made 25 cents a bale more than he would have accepted. Are the farmers better off?. Yes, they had to pay 25 cents less than they would have paid. Is the leasing company better off?. Yes, they expect to be, or they never would have rented out their trucks. Likewise the fuel distributor and the drivers would not have dealt with our entrepreneur unless they thought they would benefit by it. So everything our entrepreneur has done so far has meant benefits for those around him.

Now let us suppose the entrepreneur’s expenses add up to 25 cents a bale. This includes all the costs of doing business: wages for the drivers, fuel costs, maintenance on an of-rice, payments for the trucks, insurance premiums, clerical costs, phone bills, the wage value of his own time and so on. Added to the $5.25 he paid for the hay, that brings the total market value of the starting arrangement of things (call it the cost of inputs) to $5.50 a bale. But since the market value of the final arrangement (call it the yield) is $5.75 a bale, he has 25 cents a bale left over.

That is his profit. It is the yield minus the costs. It is his reward for increasing wealth, for taking what is valued less, and transforming it into what is valued more. It is his payment for discovering and producing a more valuable arrangement of things. He does not profit at the expense of those around him; he profits precisely because the result of his activity, when all is said and done, is more valuable than the state of affairs that existed when he started—by 25 cents a bale.

Note that the size of the profit depends on the amount of improvement overall, the size of the difference between the less valuable starting arrangement (the costs) and the more valuable finishing arrangement (the yield). It depends on the overall increase in value. The hay broker does not just have to discover who has hay and who needs it, and sell it for more than he buys it. He also has to discover good trucks to use, quick and efficient means of loading and unloading, cheap fuel, good mechanics, dependable drivers, short routes and so on, so that all these costs together are less than what he makes on the hay itself. His profit, if any, depends on his efficiency, on his producing more value than he consumes.

This efficiency is itself a social service, because it saves valuable goods for other purposes. The quicker his loads are delivered, the less hay is spoiled and wasted. The less fuel he burns and driver time he uses, the more of these are left over to deliver other valuable goods.

Losses

The opportunity for profit always involves the possibility of loss. Profits are never guaranteed in this uncertain world. The entrepreneur loses when his costs, the total value of the resources he uses up, are greater than the yield, the value of the new arrangement. He loses, and society loses, because the total stock of wealth is decreased. Suppose our hay broker is inefficient. Suppose he wastes fuel, that his drivers waste time loading and unloading, and get lost making deliveries. Suppose he leases smaller trucks than he should, so that he needs more trips to deliver the same amount. These inefficiencies might push up his total cost of delivering each bale to 50 cents, instead of 25. And his slow delivery will allow more spoilage of the hay, so that perhaps he will be able to sell it for only $5.65 a bale, instead of $5.75. Now his costs are greater than his yield, so instead of profits, he makes losses, of 10 cents a bale. This means—indeed, it is the same thing as saying—that he has used up more valuable resources than he has produced, at a rate of 10 cents a bale. He loses, because society overall loses.

Mr. Phelps still gains, of course, as do the dairy farmers and the truck leasers and the fuel sellers and the drivers. They would not deal with him if they did not see an advantage in doing so. But the society overall is worse off; it would have been better on the whole if this hay broker had never made the deliveries, if the trucks, the fuel and the drivers had been left at their previous uses (assuming they were profitable).

The greater the entrepreneur’s profit, the better off his society must be. Bigger profits mean bigger improvements, bigger differences between the resources consumed and the value produced. (They also encourage competition, of course, which tends to increase supply, lower prices, and thus reduce profits; but that’s another subject.) Profits cannot be obscene; the bigger the better! They are all to the good for society. Far from being exploiters, entrepreneurs who make profits are social benefactors of the first order, for they are the ones who create wealth, who increase the total amount of valuable goods in the world.

Who Deserves the Profits?

I first appreciated the importance of entrepreneurial brainwork, and the difficulty of the entrepreneur’s job, after work the first day I drove a baler. At the same time I realized how silly is the popular notion of “unfairness” in the laborer’s doing “all the work” for nothing more than wages, while the entrepreneur does no labor but earns all the profits.

I had been on the baler all day, the usual ten hours, from seven to six with an hour for lunch. The Nevada sun was hot, and the work was dusty. As usual, Mr. Phelps had been cruising around, checking on us from his air-conditioned, white Lincoln Continental. We were sweating for just over minimum wage. He wasn’t working, but he was making the profits. It doesn’t look fair, does it? It didn’t to me—until I looked closely.

I had had fun, and when I saw him in the machine shop talking to his foremen I called out proudly, “Hey, Mr. Phelps, I learned how to run a baler today!” He gave me a smile with a friendly sneer and said, “Baetjer, you didn’t learn to run a baler, you learned to point a baler.” In a moment of insight I understood how dependent the laborer’s contribution is on that of the entrepreneur, and why the entrepreneur deserves every penny of his profits.

What he said was true. I had baled a whole lot of hay that day, but I didn’t know a thing about it. I couldn’t even fix the small problems I had with my machine, let alone service it properly or make a major repair. Any worker could do what I had done, steering the tractor up and down the fields, but it took skilled mechanics to keep the balers running, and adjust them so that the bales would be the right size and weight. It had taken careful planning and inventory control to see that there was always baling wire and fuel on hand, and to keep spare parts in stock (they say they have them for every part of every machine!). The effectiveness of my simple, thoughtless work pulling that baler was utterly dependent on Mr. Phelps, who had arranged to get it there, had it prepared for use, and put me aboard it in a field of new-cut hay.

Sure, I had baled the hay, but who got it there to be baled? Think of the extraordinary sequence of precise, interdependent rearrangements of physical resources, labor and technical know-how that Mr. Phelps had arranged in order to produce that crop. The soil chemistry of the land had to be analyzed; on the basis of that analysis fertilizer had to be chosen, ordered and spread. The fields are not naturally even, so they had to be smoothed as well as possible, and sloped at the ideal rate for irrigation. (Most recently this smoothing of the fields is done by a laser-plane, in itself an extraordinary entrepreneurial achievement of hydraulics and laser technology.)

The alfalfa seed had to be chosen from among different strains, bought and sown, at the right time and in the right amounts. Since the valley gets very little rainfall, a complex irrigation system had to be built and maintained, and the irrigation carried out on time, in the right amounts, and at the right rate. When the alfalfa started to bloom, it had to be cut, weather permitting, as dose as possible to that brief time when the protein content in the plants is highest. The drying hay had to be monitored for moisture, so that the bales would be neither damp nor dried out.

At each step of the harvest process, the necessary machines, costing tens of thousands of dollars each, had to be ready. There are the “swathers,” which cut, crimp and pile the hay into windrows; the balers; and the harobeds, computerized marvels of levers and platforms, which pick up, load and stack the bales. All must be in use on time, because once the hay is cut, it must be dried, baled and stacked without delay to maintain its value. During the harvest, the hay broker must be contacted and negotiated with, the fields and irrigation ditches repaired, and the next round of irrigation planned.

Every step of this extraordinary process must be directed by Mr. Phelps, the entrepreneur. Each crucial decision, on which depends success or failure, profit or loss, must be made by him, either directly or through the men he has hired to make them. In any case, the responsibility for the result, be it credit or blame, is his. One good decision made in that white Lincoln Continental was worth a whole day’s worth of pointing a baler, and a whole summer’s worth of baling could not make up for one bad decision. All I did was steer. He did the thinking. That is why the entrepreneur deserves the profits: he makes them possible!

The successful entrepreneur, one who makes business profits in a market economy, is a social benefactor. (In a mixed economy, with government intervention and privilege, things are often different, but that, too, is another subject.) Indeed, the profiter is the most important, most significant kind of benefactor any society has, because such a person provides, in ever greater measure, the wealth all the rest of us depend on to support and enrich our lives.

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