The Role of Profits –and Losses | Basic Economics by Thomas Sowell | Ch. 6
In the sixth chapter of Basic Economics, Sowell continues to explain in depth the concept of profits and losses in business which he began in the fifth chapter. This is a really long chapter, so bear with me as I summarize it.
If you want to look at my previous chapter summaries of this book, please click here.
Again, as stated in chapter 5, because we are looking at general economics, it's important to realize the role that both profits and losses have. In this way, businesses need to keep track of both their income from customers, as well as expenses paid for labor, raw materials, utilities, and other similar things. In this way, using prices can help stop a business from spending too much on what isn't needed, or not enough on what consumers actually want.
But businesses also cut profits in order to compete. When a single business lowers the price of items it sells, other businesses that sell similar products often lower their prices as well, since most consumers will buy the cheapest one. In this way, the consumers often win, because they will be able to buy the same things for the cheapest amount.
Considered by many to be a 'dirty word', profit is often thought to be the consequence of greed. However, in an economy, profits are an indispensable aspect of an economy.
First, profits provide incentives for business owners. For example, if a business is government-owned, it doesn't need to innovate in order to stay on top of the competition, since its survival isn't guaranteed by the public, but by pleasing authorities. In a free market, businesses are incentivized to take risks, because those risks may give the business a boost above its competitors.
As an example, over the past two decades, AMD and Intel, two semi-conductor manufacturing giants, have had constant competition to see which company would eek out the other in building the best computer chips. Both have had massive profits, losses, cut thousands of employees, and other effects within their companies. But the result was that we, as consumers, have been able to take advantage of faster and better computers through the decades.
In another example, in India, prior to 1991, wouldn't allow foreign produced cars. Their most popular vehicle, the Hindustan Ambassador, was a piece of tech that was 40 years behind the rest of the world. After India opened up, the Ambassador improved, but still fell behind. Instead, Marutis, Toyotas, and Volkswagan became more prominent. The end result? More Indians were able to purchase much better and more reliable vehicles.
The argument here is that while capitalism's cost of profit may very well be “greedy”, socialism's cost of inefficiency is much worse, and is weeded out by capitalism's profit incentive. Or as Sowell puts it, “Profit is a price paid for efficiency”.
But it's not simply a price to be paid. Profits are simply what's left over after all expenses and employees are paid. Since that leftover can be zero or even negative, the owner must pay special attention to (i.e. monitor) what's going on in order to make the business a success. In this reality, rather than profits being the result of greedy charges, profits are often actually the result of business owners lowering prices and reducing costs—the opposite of the expected!
When people invest into a business, their hope is that the rate of return (i.e. the profit they will receive as a result of that investment) will be high enough to maintain that business. For example, if someone invests $10,000 into a grocery store to buy bread, they need to make sure that the demand for that bread is high enough that the bread won't sit on shelves molding before it is sold. As such, the price to sell that bread needs to be low enough to create demand, but high enough to hopefully make some return on it. If it makes a positive return, the business will use that money to buy more bread (or other goods) to sell, and thus continue to supply the demand of their customers. If not, then the business will eventually fold. This rate of return is often quite low for most businesses, ranging anywhere from 2% to 7% on average according to recent studies (after taxes).
In this way, the profit of selling a product and the profit of investing into that product is different. If you sell a product for a low price, you may only earn 1 cent in profit. However, if you invested into that product and are selling hundreds of those, then the profit made on the investment across the spread of selling all those hundreds is much higher. This is the primary way businesses make a profit, called economy of scale.
Costs of Production
Similarly, businesses must understand the cost to produce a product or service. These kinds of costs depend on the scale of production. A business owner may mass produce an item (e.g. a car), but if those cars don't sell very well, then the cost of producing them is a much bigger drain on the business. Thus, many companies attempt to sell more by spreading their businesses out to reach more customers. By doing so, they can keep their costs lower, because it's more probable that they will sell more.
But there's a limit to this. And the limit comes when a company becomes so large that it is unable to correctly monitor and coordinate the business efficiently. For example, a banking business might be doing really well according to the numbers reported to the top brass. But, unbeknownst to them, some of the local banks under their jurisdiction could be doing risky or even criminal work. Even if those local jurisdictions aren't doing anything sketchy, the ability to manage those chains may still be slow and clunky. In such cases, these big behemoth may be unable to respond well to changing markets, thus allowing smaller competitors to come in and take root. This is called the diseconomy of scale.
In this way, once again, profits can incentivize better management. When the local businessmen understand that monitoring their small locales efficiently will produce a greater profit for them, they will be more attentive to the needs of their customers. This is why and how restaurant franchises can be successful. As pioneered by Howard Johnson in the 1930's, when the local franchisee puts up their own money for the franchise, they will pay more attention to whether it's doing well or not.
There is also the question of capacity. The capacity of a business must be able to handle when demand for it has peaked, and when it is in the off-seasons. This creates pressure for businesses to adjust their prices so that, depending on the season, different services or products will have different costs. It's why hotels or cruise-lines will have such cheap discounts in months that people don't travel much in, but much higher ones when there is a lot of travel going on.
What about businesses that want to pass their costs onto others? For example, what if a business decides to up their price for their customers when they are suddenly taxed at a higher rate? In a sense, this depends on whether the business is local or has been using the principle of economies of scale to extend their reach. But in both cases, there will eventually be competitors that come in and offer lower prices for customers. If that previous business doesn't continue to have lower prices, their customers will leave, and they will be bankrupt soon. In this way, costs may be passed on at first, but eventually, things will even out, and businesses won't really be able to do so. Instead, they will need to come up with new innovations to continue to be competitive.
Specialization and Distribution
As businesses get larger, there is one rule that can't be broken: no single business can keep track of everything that is going on. They must rely on local businesses to have intimate knowledge on what those local customers will want. These locals businesses are often called “middlemen”, and unfortunately, the economic reality of these people won't be going away any time soon.
This is because middlemen provide something a growing business cannot —specialization in a specific area. These specializations allow middlemen to be much more efficient and cost effective at doing a certain thing than others. Businesses rely on these middlemen to cut costs, because they understand how to more effectively allocate the scarce resource with alternative uses. As Sowell notes:
Despite superficially appealing phrases about “eliminating the middleman,” middlemen continue to exist because they can do their phase of the operation more efficiently than others can.
In this way, once again, efficiency is the name of the game. If a farmer can use someone else to transport their goods to sell in another locale, rather than having to use his own scarce resource (i.e. time and labor) to do so, they will use that middleman. In these cases, even middlemen may be in competition with each other, and again, prices will dictate how they compete.
Socialist economies often eliminate these middlemen, though for pretty rational reasons, since these economies function differently. In such economies, since competition doesn't drive down prices, the real cost to produce something is much higher than the norm. When there is no financial incentive, middlemen simply don't exist, and businesses need to do all the work to produce everything as they are told to, as governments won't provide the labor middlemen would usually do (as they either don't care, or couldn't be bothered).
The lack of specialized labor forces a rise in cost, since inefficiencies in the system aren't taken care of. Even with huge surpluses that require inventories, the products produced aren't necessarily reliable, and the people supplying them have no incentive to be reliable either. But storing products still has costs (i.e. upkeep, maintenance, etc.). This all adds to costs, and since prices aren't used as knowledge to easily inform costs, those costs just get higher and higher. All the different parts, from labor to products to service, of an economy are extremely complex, and no centralized authority would be able to coordinate it all.
An argument Sowell makes is profits is better than inefficiency, thus making socialism (inefficiency) inherently worse than free market capitalism (profits). We can see this when we look at government-sponsored agencies that have been taken into the private sector, even today. Think about university-style education, much of which is funded publicly (even so-called private universities). The cost today of attending universities is so abysmally high, that it is actually more worthwhile to go to a trade school than attend a university in the United States. Even Google has seen this, and is offering its own online education courses that are much faster to finish, and give you just as much merit as a four-year bachelor's program.
Crypto and the Role of Profits and Losses
The idea that big corporations being unable to respond to changing markets is a fitting analog to today's crypto world. After all, the entire cryptocurrency ethos was birthed from the 2008 global financial crisis, when banks abused their ability to sell mortgages to those who couldn't afford them.
In such an environment, cryptocurrency — which allows the transfer of value around the world without centralized third-parties — was invented. Even today, when I can use XRP to transfer thousands of dollars instantly to a friend around the world in seconds, and I can put crypto into a savings account that earns me interest that's literally 1000% or more than what normal banks could give me, banks by and large still haven't adopted this technology.
But I think it's important to realize that, even if crypto were to become ubiquitous, this doesn't mean that the middlemen will be gone. While banks and financial institutions may or may not change the way they work for the better, there will almost always be people who can do certain things better and faster than the average person.
The example I would use today would be Celsius Network versus something like Compound or Aave. Celsius Network is a service that offers users and customers interest on their coins stored in the network, as well as loans for users that want to borrow crypto. It is a centralized company. Compound, on the other hand, is basically a completely decentralized exchange, that also offers interest and loans, but through algorithms rather than a company.
When we look at the highest rates of return achieved, Compound (and Aave) certainly beat out Celsius soundly. However, if we look at average rates across time, Celsius Network has been the steadier of the two by far. Over the course of the last six months, it has been able to hold an interest rate for USD stablecoins above 8%, while the same stablecoins on Compound have fluctuated wildly between 2% and 10%. So while decentralized exchanges have allowed for very high returns, these returns are often peaks in a volatile market. The middlemen, it seems, still offer more for those who prefer stability.
There is another side to it, though. I firmly believe that the next phase of crypto is going to be governance. It's actually already happening. And this is where it gets tricky. Because governance on the Internet is very different from governance based on geography or nationality. But if we're looking at the basic idea of people coming together to do something, I think that will probably be the best description of blockchain governance going into the future.
And, in a sense, I believe that paying attention to economists like Thomas Sowell will be a large boon to those who want to get involved in governance. While many people in blockchain currently have a desire to do good for the world, we must measure our intentions by their economic output, not just our idealistic moralities. Our participation in blockchain governance need to be informed by economic realities — realities that have been manifested time and time again throughout history. We can't let our intentions block ourselves from seeing if what we're doing is actually good, or just morally justified.
After all, even the Soviet Union thought their intentions were good.