What Is Profit? The Classical Tradition

What Is Profit? The Classical Tradition

At many points the theory of interest coincided with the theory of profits. Indeed, some authors discussed them interchangeably, and others found that interest rates and profit rates were de­termined by the same factor—the earning power of capital. There are, however, a number of different theories as to the meaning, the origin, and the rate of profit. The early writers, prior to Adam Smith, made no clear distinction between interest and profit, although from the literature it is obvious that the businessmen of the time, conducting their affairs many times on borrowed capital, must of necessity have paid interest, and con­sidered profit as the residue. The Physiocrats and Mercantilists failed generally to note any difference between interest and profit. Adam Smith tried to clarify the meaning of these terms. He pointed out that profits were not wages paid for any kind of supervisory labor, but were a distinct income derived solely from capital or stock, as he called it. He was careful to caution read­ers against an error quite common even today, namely, that of lumping both the earnings of capital and the wages of proprietor-ship as "profits," when a business enterprise was conducted by a person who furnished his own capital. This point was elaborated by J. B. Say, a close follower of Smith's theories. Although Say's terms profits of industry and profits of capital were in themselves somewhat confusing, he tried to separate the wages of the entrepreneur from his returns as an investor. Profits of industry, he said, included wages paid to common labor and to the super­visors and directors of the enterprise, whereas profits of capital included elements of interest and payment for risk. Say was ex­tremely critical of the English language at this point, claiming that the absence of any word in English corresponding to the French "entrepreneur" was responsible for the failure to make the distinctions which he and Smith had pointed out. When the rate of profit in relation to the risk and the length of waiting time was low, capital would neglect such ventures in favor of more lucrative ones. This withdrawal would cause the competi­tion to slacken (due to the lack of new ventures and the failure of old ones). A rise in profits would follow until risk and waiting were well enough rewarded to encourage the investment of new capital.

The classical tradition continued with the writings of Ricardo and Mill. Ricardo is never very clear on the meaning of profit. In some instances it was discussed as a residual amount after labor was paid. Since the subsistence theory of wages implied a stable amount for this factor, the increase or decrease in the total income would affect profits. In other discussions Ricardo stated the conviction that the return on capital was payment for past labor. It is always well to keep in mind that Ricardo speaks usually of long-term principles, under systems of perfect competition; although once in a while the peculiar movements of the present broke into the exposition. Certainly the reward of capital as pay­ment for the labor necessary to produce it was a "natural" pay­ment, as Ricardo saw it, modified at any given time by the short-term conditions of the market.

Both Mill and Ricardo were interested in the effect of popula­tion movements on profits. They both believed that the increase in population resulted in use of the less productive land; and capi­tal, earnings, and, of course, profits would fall, tending to ap­proach zero. Advances in civilization, however, of which inven­tions were an important part, would go a long way to preserving a substantial rate of profit.

In his discussion of the relation of profits to other forms of in­come, Mill incorporated into his own thought some of the ideas of J. B. Say. He advised that the returns on business enterprise should be broken down into the return on the use of capital, a payment for risk, and wages to the entrepreneur. Just which of these should constitute true profit, Mill did not say.

This discussion of the elements which constitute profit has continued on into the 20th century. Both Alfred Marshall and J. B. Clark proposed solutions to the difficulty. Marshall believed that profits were made up of the same divisions as described by Mill, but Marshall also added the idea of profits as combination earnings. This was an aspect of profit which appeared only as large scale industry began to take shape. Whereas, in earlier days the owner of a business enterprise invested his own capital, managed the business, and assumed the risk, in modern times each of these services could be and was frequently performed by a specialized group for a fee that was fixed in amount by market conditions. Profit, then, would be the result of the skill with which these factors were brought into combination in a particular branch of industry. This seemed to have certain advantages from a quantitative standpoint. If, as in large corporations, all the traditional elements of profit could be bought at a stipulated sum, even risk, the surplus over and above all costs could be nothing more than the earnings of an intangible aspect of the business enterprise best characterized as the skill in integrating the factors of production, at a certain time, for a certain purpose.

Not content with this explanation, Marshall and Clark separately, proposed that profit be considered as the product of market disequilibrium. They assumed a hypothetical situation in which perfect competition and the free application of supply and demand brought all aspects of the economic process into balance. Under such a circumstance there would be no profit. Such a situation could never exist; however it was theoretically possible and interesting. Its failure to materialize was an indica­tion of the operation of such unpredictable forces as unexpected shortages, losses, and demands. Marshall coined the term quasi-rent to cover the short-term earnings of the forces of production which arose because of the unbalance in the economic process. Although there is no reason why quasi-rent should not be sub­stituted for the term profit to define such earnings, there does not seem to be any significant gain from so doing.

Contemporary economists have delved deeply into the ele­ments of profit, hoping to grasp a factor which would seem to give a fairly adequate explanation of profit for the modern type of business enterprise. When, as in many industries, all of the con­stituents of profit, such as wages of an entrepreneur, return on invested capital, and payment for risk-bearing, are met in ad­vance for a definite sum, the source of profit becomes an elusive and complicated factor indeed.