Three Views on Profit

My semester is over and I’ve just turned in my grades.  One of the courses I taught this term was “History of Economic Ideas,” and one of my final examination questions asked students to compare the views of Karl Marx and Joseph Schumpeter with the Marshallian-neoclassical view on profit.  These views are very relevant to the way people assess the workings of a market economy today.

Marx, building on a labor theory of value, believed that the value of goods is equal to the value of the labor used to produce them.  Therefore, if all of the revenue from the sale of goods does not go to the laborers, they are not paid their full value.  Profit was obtained only by exploiting labor, which capitalists were able to do because they controlled the jobs.  They paid labor less than it was worth, and kept the difference as profit.

Marx was a supporter of unions, because unions could give workers some collective power to limit their exploitation.  Legislation like the proposed “card check” to extend union representation, and the ceding of substantial shares of GM and Chrysler to the UAW are some examples of Marx’s ideology at work.  Although his brand name rarely is attached to the selling of his ideas, those ideas remain current today.

In the Marshallian-neoclassical view, which characterizes modern mainstream economics, competitive equilibrium is the benchmark for economic efficiency, and profit (beyond a normal profit to keep firms in business) is a sign of inefficiency.  Profit results either from markets being out of equilibrium, which is inefficient, or from monopoly power of firms, which also is inefficient.

Thus, antitrust laws are employed to limit firms’ monopoly power, mergers are closely scrutinized, and anti-competitive behavior of firms is in general illegal.  Profits are undesirable because, in this view, profits signal inefficiency.

While both the Marxist and Marshallian-neoclassical views hold profits to be undesirable, Joseph Schumpeter viewed them to be necessary.  Schumpeter said profits were the return to successful innovation, and economic progress depends on profits.  Profits give entrepreneurs the incentive to innovate, and the profits they earn show the value of that innovation.  Without profit there would be no economic progress, and without economic progress there would be no profit.

Schumpeter described the process as “creative destruction,” as innovation in the form of new goods and new production processes displaces existing goods and existing processes.  Profits are a sign of efficiency, because they are the return to innovation that continually improves people’s standard of living.  Consider how much better off we are today than people a century ago, or even a decade or two ago.  Without profit, that innovation would not occur.

The hostility that mainstream America, and the mainstream media, shows toward profit has a solid academic foundation, but a foundation that ignores the way that economic progress continually makes our lives better.  When pundits argue that profits are a sign of inefficiency and exploitation, academics can go back to Marx and Marshall to make the case.  But Schumpeter showed that profit is essential.  The Industrial Revolution would not have occurred without the ability of entrepreneurs to profit from their innovations.

Marx is a bit outside the mainstream these days, but the neoclassical mainstream in economics provides several reasons for viewing profits undesirably, and that’s the bulk of what our university students get in their economics classes.  If this is what we are teaching our students, no wonder they view profits with suspicion, as citizens, as journalists, and as politicians.  A larger dose of Schumpeter is needed.

Randall G. Holcombe is Research Fellow at the Independent Institute and DeVoe Moore Professor of Economics at Florida State University. His Independent books include Housing America: Building Out of a Crisis (edited with Benjamin Powell); and Writing Off Ideas: Taxation, Foundations, and Philanthropy in America .
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