We beat conventional wisdom with a stick
30 April 2016 16:45 (South Africa)
Opinionista Ivo Vegter

What's obscene about profit?

  • Ivo Vegter
    Ivo Vegter

    Ivo Vegter is a columnist and the author of Extreme Environment, a book on environmental exaggeration and how it harms emerging economies. He writes on this and many other matters, from the perspective of individual liberty and free markets. He is seldom wrong.

Whenever someone decries the “obscene” profits of a company, they are almost always wrong. There are exceptions, but not in a free market populated by capitalists.

It is not so common, these days, to assume that profit is bad. It remains common, however, to assume that some level of profit is necessary and good, but some other level of profit is “excessive”, or “obscene”. That if someone makes a great deal of profit, then they must be charging too much and unjustly exploiting helpless customers.

For example, when Exxon reported big profits while consumers were paying a lot for fuel at the pump, they complained about “obscene profits” over at that haven for malcontent and woolly economics, alternet.org.

When Sasol did the same, a South African government team leapt to the task of figuring out how to expropriate those ill-gotten gains to fatten the state's coffers instead.

Sometimes, these arguments are taken to ridiculous extremes, such as when the Workers International Vanguard League considers the content of a box of cornflakes to be worth 30 cents, while the box sells at retail for R17. “A profit margin of over 5000%,” the communists claim, without the slightest thought for how the contents of the box might have got from 30 cents worth of maize on a farm in the Free State to a conveniently packaged product at Pick 'n Pay in Norwood.

To test this theory, that prices are a consequence of excessive profit margins, let's try a little thought experiment.

I'd like you to procure for me a chair. I'd like it to be a wooden Morris chair in the Mission style. I don't much care if it's new or antique, as long as it's nice. Since I saw a genuine antique on eBay for about R10,000, I'll offer you R7,500.

Your job is now either to find me a cheaper chair, such as this one, and to sell it to me for a R2,000 profit, or to make me one. If you do the latter, the amount of profit you make depends on whether you buy a traditional, but now rare and expensive wood, such as oak or mahogany, or opt for a less expensive, more sustainable wood. (See how your profit motive is an incentive not to pillage scarce natural resources, by the way?) Your profit then depends on how quickly and efficiently you are able to make the chair. If you have a factory and a few workers, you'll spend far less time, and consequently make far more profit, which means you can supply a whole lot more people in the time it would otherwise take you to make one chair with hand tools.

In any case, your profit margin will depend on your cost, not on my price.

Let's consider another way of structuring the deal. This method is very common when governments award contracts, and it's called “cost-plus”. Let's say I'm daft enough to offer you such a deal, and agree to pay you for your costs, plus a “fair” profit margin of R2,000. Now it matters nothing to you whether you source me that R10,000 chair, or the R5,000 one. And if you make it yourself, then (a) you're an idiot, and (b) you can take as long as you like and use whatever wood happens to be at hand. Your profit is guaranteed no matter what you do. Your profit margin doesn't influence my price, but your cost and efficiency does, and there is no incentive at all for you to deliver a good product on time. This is a key reason why non-profit organisations are likely to produce a worse product at a higher price than for-profit companies. They have little reason not to.

Now if all my friends also want Morris chairs, you run into trouble. At first, you'll refuse my offer of R7,500, because some of my friends are much richer, and will easily offer more than I did. So I don't get my chair.

Then, someone else spots the new going price for Morris chairs, and realises that his furniture factory can turn them out much faster and cheaper than you can, so, speculating greedily, he goes into competition with you. He isn't motivated by pity that I don't have a chair. He is motivated by the fact that you're making high profits, and he wants a slice of the action. And he isn't the only one. Greedy capitalist woodworkers from all over the district hear the rumours, and speculate wildly to get in on the Morris Chair Boom, known in pretentious and ambitious start-up circles as the Great Mission-Style Revival. Banks fall all over themselves as they offer half-secured loans at discount interest rates to fuel the speculative frenzy.

With each new producer that enters the market to fill this extraordinary demand for Morris chairs, prices decline, even though the variety on offer increases and each producer tries to outshine his competitors by offering better wood and workmanship, or sourcing the best antiques.

Eventually, I manage to score a far better chair for far cheaper than my neighbour did, and my demand is satisfied.

Sadly, nobody foresaw that demand would drop off rapidly after my friends and I all had Morris chairs, because we're not very fashionable, and nobody wants to be like us.

Pity the last guy to enter the market, a speculator who mortgaged his house and liquidated his pension to build a factory to supply what he thought was endless demand. The poor guy goes bust. So do a few others who over-invested. And so it should be, because they miscalculated future demand. They should have hedged.

The point of this story is that high profits have nothing at all to do with the cost of production, or with “excessive” prices. There's no such thing as an “excessive” price, or a “fair” price. Price is simply determined by relative supply and demand. It is premised on the notion that the factors going into supply – labour, raw materials, skills, capital goods – are always scarce, and that as a consequence only some of our potentially infinite demand can be satisfied. (Would that this were not true: then everything would be free.)

If not enough is supplied to meet demand, prices rise, and producers get a signal that they should invest in expansion, or should switch from producing other, less profitable things. When too much is supplied for prevailing demand, prices fall as producers compete for your business, which signals to other producers not to bother trying to break into the market, and to existing producers to scale back their supply.

So, when you see a shortage, such as in the demand for energy or food, it is expected that prices should rise. The consequently high profit margins are a signal for expanded and new production. Thus, high profit leads to the ultimate social good: satisfying demand.

When you see “obscene profits”, you can – with a few notable exceptions – be sure that you're seeing a market in which production is insufficient to meet demand. You're seeing a shortage. And you're seeing it in the only way that it can be seen: through the price signal that attracts producers to remedy that shortage and meet the urgent demand.

Tax that price signal away, or worse, set maximum prices by law, and you're telling producers not to expand production or not to enter the market. You're saying you're okay with that shortage. In short, you'd be wrong.

Moreover, by taking money away from the capitalists in good times, you're crippling their ability to efficiently allocate capital. Not only should the last entrant to our Morris chair market be willing to risk his capital, but the rest need the capital to rejig their factories and turn to producing other goods, for which market prices signal that there is more urgent unfulfilled demand. Decorative rustic wheelbarrows may be the new rage, or school desks are urgently needed.

I mentioned exceptions. There are a few obvious exceptions, and they more often than not confuse what really is quite a common-sense issue.

If competition is artificially restrained, by means of regulatory hurdles or outright cartel or monopoly licensing, the dynamic described above does not work. If no new competition can arise, there's little reason to heed the price signal and invest in expanding production. Rather just sit back and cream off the profits while the good times last. In such cases, profits really are obscene. A classic South African example is Telkom's profit a few years ago, or those of our casino operators.

Another cause for profits that really are unjust involve subsidies, such as the deplorable situation in which BHP Billiton's aluminium smelter gets “an effective [electricity] subsidy that will possibly even surpass the revenue from the sale of product in years to come.”

Some companies are favourably treated in terms of tax, and others profit because they are protected from competition by means of import tariffs. In the worst cases, companies turn a handsome profit thanks to generous bailouts at taxpayer expense. All of these exceptions have one thing in common: ill-advised interference in a market by the state.

In a market that operates freely and without interference, profits – and especially very high profits – are the mechanism by which shortages are addressed.

High profits are the very force that signals production to fulfil demand and push prices back down. Forcing them down by confiscating them or setting maximum price levels, will leave profits unmade, that is true. But it will also leave demand unfulfilled.

Fewer Morris chairs may just mean that I can't afford mine, while my rich friends can afford the ones they wanted. But fewer boxes of cereal, my dear Workers International Vanguard League, will mean no breakfast for workers and their children.

That, to use a well-known term from common-sense economics, is truly “obscene”. DM

  • Ivo Vegter
    Ivo Vegter

    Ivo Vegter is a columnist and the author of Extreme Environment, a book on environmental exaggeration and how it harms emerging economies. He writes on this and many other matters, from the perspective of individual liberty and free markets. He is seldom wrong.

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