[An updated version of this article can be found at Profits in the 2nd edition.]
In a capitalistic society, profits—and losses—hold center stage. Those who organize production efforts (the capitalists) do so to maximize their income (profits). Their search for profits is guided by the famous "invisible hand" of capitalism: the highest profits are to be found in producing the goods and services that potential buyers most want.
Capitalists earn a return on their efforts by providing three productive inputs. First, they are willing to delay their own personal gratification. Instead of consuming all of their resources today, they save some of today's income and invest those savings in activities (plant and equipment) that will yield goods and services in the future. When sold, these future goods and services will yield profits that can then be used to finance consumption or additional investment. Put bluntly, the capitalist provides capital by not consuming. Without capital much less production could occur. As a result some profits are effectively the "wages" paid to those who are willing to delay their own personal gratification.
Second, some profits are a return to those who take risks. Some investments make a profit and return what was invested plus a profit, but others don't. When a savings and loan or an airline goes broke (and there have been a lot of both recently), the investors in those firms lose their wealth and become poorer. Just as underground miners, who are willing to perform a dangerous job, get paid more than those who work in safer occupations, so investors who are willing to invest in risky ventures earn more than those who invest in less risky ones. On average those who take risks will earn a higher rate of return on their investments than those who invest more conservatively.
Third, some profits are a return to organizational ability, enterprise, and entrepreneurial energy. The entrepreneur, by inventing a new product or process, or by organizing the better delivery of an old product, generates profits. People are willing to pay the entrepreneur because he or she has invented a "better mousetrap."
Economists use the word interest to mean the payment for delayed gratification, and use the word profits to mean only the earnings that result from risk taking and from entrepreneurship. But in everyday business language the owner's return on his or her capital is also called profits. (In business language the lender's return is called interest, even though most lending also entails some risks.)
Attempts have been made to organize productive societies without the profit motive. Communism is the best recent example. But in the modern world these attempts have failed spectacularly. Although ancient Egypt, Greece, and Rome were successful societies not based on the profit motive as we understand it today, since the industrial revolution began in the late eighteenth century, there have been essentially no successful economies that have not taken advantage of the profit motive.
While most profits flow to the three previously mentioned necessary inputs into the productive process, there are two other sources of profits. One is monopoly. A firm that has managed to establish a monopoly in producing some product or service can set a price higher than would be set in a competitive market and, thus, earn higher than normal returns. (Economists call these extra returns economic rents.) Historically, one can find examples of monopolies that have been able to extract large amounts of income from the average consumer. Some railroads, which were granted exclusive rights-of-way and given huge subsidies by the federal government, were such monopolies in the second half of the nineteenth century.
Although some monopoly profits obviously exist in any economy, they are a very small portion of total profits in any rich society. In rich societies most of our consumption consists of either luxuries or products that have close substitutes. As a result the twentieth-century monopolist has less power to raise prices than the nineteenth-century monopolist. If he does raise prices very much, the consumer simply buys something else. Professional football, for example, is a monopoly. But Americans have lots of ways to get pleasure without watching football. The National Football League, therefore, has some, but not much, power to raise prices above the competitive level.
The second other source of profits is "market imperfections." Suppose firm A sells a product for ten dollars while firm B sells the same product for eight dollars. Suppose also that many customers do not know that the product can be bought for eight dollars from firm B and, therefore, pay ten dollars to firm A. Firm A gets an extra two dollars in profit. In a "perfect" market, where every consumer was completely informed about prices, this would not happen. But in real economies it often does. We all know of instances where we bought a product at one price only to find later that someone else was selling it for a slightly lower price. Profits from such "imperfections" certainly exist, but here again they are not a large fraction of total profits.
When it comes to actually measuring profits, some difficult accounting issues arise. Suppose one looks at the income earned by capitalists after they have paid all of their suppliers and workers. In 1989 this amounted to $971 billion, or 20 percent of GNP. Some of this flow of income represents a return to capital (profits). Some of it needs to be set aside, however, to replace the plant and equipment that have worn out or become obsolete during the year. It is hard to say exactly how much must be reinvested to maintain the size of the capital stock (what are called "capital consumption allowances") because it is hard to know precisely how fast equipment is wearing out or becoming obsolete. But the Department of Commerce thought that $514 billion needed to be set aside to maintain the capital stock in 1989. This left $457 billion for other purposes.
Many capitalists are small businessmen (technically known as single proprietorships) whose "profits" include their wages. No one knows how to disentangle these two streams of income. In the corporate sector, where this problem does not exist, profits after subtracting capital consumption allowances amounted to $273 billion, or 9 percent of the GNP produced in the corporate sector. Some of these profits, however, are paid to the government in corporate income taxes. After the payment of taxes, $137 billion, or 5 percent of the corporate GNP, was left as profits. Of this sum capitalists paid themselves $81 billion in dividends and put $56 billion back into their businesses as new investments.
Table 1 provides some information on profits by industry over time. In 1989 the highest profits were earned in pharmaceuticals (25.5 percent), the lowest in building materials (4 percent). Over time, profits rise and fall with the onset of booms and recessions (see table 2). After tax, corporate profits for nonfinancial corporations have ranged from over 9 percent of the GNP produced by nonfinancial corporations in boom years in the sixties and seventies to less than 5 percent in the recession of the early eighties. No matter what the year, corporate profits as a percent of GNP are far below 45 percent, the level, according to a Gallup poll, that many college graduates believe them to be.
The mideighties saw a steady decline in profits as firms acquired tremendous debt in the merger and takeover wars. They reached a low of 3.4 percent in 1986. Because the owners were effectively withdrawing their own capital from their businesses (substituting debt for equity), they were providing much less of the total capital stock and, therefore, earning less in profits. Profits went down as interest payments to lenders went up.
Capitalism requires profits, and profits require ownership. Property ownership generates responsibility. A decade ago I wrote an article about communism entitled, "Who Stays Up with the Sick Cow?" Without ownership the answer was too often "No one," and the cow and communism died.
Lester C. Thurow is the Jerome and Dorothy Lemelson Professor of Management and Economics at MIT's Sloan School of Management. In 1977 he was on the editorial board of The New York Times. From 1983 to 1987 he was a member of the Time Magazine Board of Economists. Shortly after graduating from Harvard, he was a staff member with President Johnson's Council of Economic Advisers.
Knight, Frank. Risk, Uncertainty, and Profit. 1921.
Thurow, Lester. "Who Stays Up with the Sick Cow?" The New York Times Book Review. September 7, 1986: 9.