Philip Pilkington: Profits in a Capitalist Economy – Where Do They Come From, Where Do They Go?

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

The engine that drives enterprise is not thrift, but profit – John Maynard Keynes

Profits are without doubt the key driving force in a capitalist economy. No respectable entrepreneur would try to sell goods or services were they not to make some sort of profit out of it. And yet profits are spoken of surprisingly little in mainstream neoclassical economics. For the neoclassicals there is, in fact, a deafening silence surrounding the role that profits play in the functioning of our economies; economies that are, of course, founded on the profit motive.

For example, if we turn to a fairly standard mainstream textbook – in this case Samuelson and Nordhaus’ ‘Economics: Fifteenth Edition’ – we find just how little neoclassical economics concerns itself with profits (some will say that Samuelson is a Keynesian, indeed he would probably have said so himself, but Samuelson is not really a Keynesian, his ‘neoclassical synthesis’ was just a grafting of a vulgarised Keynes onto the neoclassical edifice). This 800-odd page book devotes all of three pages to the topic. And even in this short space the authors are vague and fuzzy. We are told that profits come from ‘a hodgepodge of different elements’; that they are earned as a ‘reward for bearing risk’ and that occasionally they take the shape of ‘monopoly returns’. At no point do the authors even dare to suggest where profits come from.

This must appear to anyone with even a cursory interest in how our economies work as a rather unusual evasion. And it should. Usually when people are evasive on such important issues it is because – whether they know it or not – they are hiding something. In this case the authors are – again, whether they know it or not – hiding something extremely important; namely: the origin, source and function of profits in a capitalist economy.

There is a Microeconomist Inside All Our Heads: He Must Be Destroyed

The problem when it comes to thinking about profits is that, as with most economic concepts, we all come to the table with preconceived ideas that we have derived from our personal experiences. We have experienced the generation and acquisition of profits in our everyday lives and we seek to carry this over into how we conceptualise the world.

But our perceptions are limited to only the crudest of microeconomic phenomena. We might recall that fair time when we set up a lemonade stand as a child. We bought the lemons and the sugar, mixed them together and sold them on the street outside. Kind passersby and neighbours then bought the bitter liquid and politely sipped it through twisted lips. Our profits – if indeed we made any – came from selling our lemonade for more money than we bought the ingredients. Add to that a pinch of labour and a dash of entrepreneurial spirit and you’ve got a perfect recipe for profits.

So this is how we instinctually think about profits. Indeed, if we read Samuelson, Nordhaus and many other mainstream economists we find that rather than actually seeking to understand the world around them, they too are trapped in the sweet memories of their childhoods.

The microeconomic ideas of the mainstream economists give us little insight into how profit works in a modern economy or what role it plays. Neoclassical theory, as discussed above, tries to push profits to the margins. This is because to truly recognise the function of profits in a capitalist economy would destroy many aspects of neoclassical theory itself.

Neoclassical theory is an ideology of truck and barter – a trumpet sounded for commerce of all sorts. It does not ask any real questions about origins. Instead neoclassicals focus on the superficial. They ask questions about the child and his lemonade stand, rather than inquiring about where the child’s profits came from given the broader economy. Their theories are heavenly and idealised structures – built on foundations of air.

In order to stay firmly grounded we need to explore just where profits come from given the broader economy and through what processes they arise. When we discover the true origins we can then ask all sorts of questions; questions about monopolies, about financial instability and about the pristine, efficient markets of the neoclassicals – and why, in the long-run, the latter can never really generate profits in the macroeconomy.

These questions will be put on hold for now and broached in later pieces. What we must first come to understand is that money doesn’t grow on trees – and neither do profits. They have a specific and important place in how a capitalist economy functions. It is to this that we now turn.

A Capitalist, A Bank, Ten Workers, Two Presidents and a Giant Loaf of Bread

Like many ideas in macroeconomics the theory of profits is remarkably complex – or, rather, it becomes so very quickly when looked at in any detail. And yet we can essentially boil it down to a fairytale; a fairytale about a capitalist, a bank, ten workers, two presidents and a giant loaf of bread.

We imagine an island. On this island we find a capitalist (or an ‘entrepreneur’ to use more politically correct language), a bank, ten workers and a government. Five of the workers are bakers and five of them are builders. We assume that the capitalist does not consume anything and that there are no input costs apart from the cost of labour. In addition to this capital goods (machines etc.) do not depreciate in value (wear down etc.). Finally, the workers do not save. In other words: they consume all that they earn.

(This seems silly but we can include these variables in more complex models, some of which will be dealt with in more condensed form later. For now let us just say that all this occurs because the island is magic and a wizard created it…).

The capitalist must pay the workers at least $1 a day as the government has a minimum wage law in place. So, the capitalist hires five workers (the builders) to build a bread factory – spending $5. He then hires the other five workers (bakers) to make bread in the factory – spending an additional $5. All of this money is raised from the local bank which charges him a rate of $1 interest a day. The capitalist ends up with a giant loaf of bread which he sells to the workers for all their wages – the bread thus sells for $10 and each worker gets a 10% share.

We must stop here for a moment to highlight an important fact. Note that the overall amount of spending power in the economy – that is, the workers’ aggregate wages – determines the price of the bread. The bread is divided into ten because there are ten workers, but it is the amount they are paid that sets the price of the bread. More on this in a moment, for now we get back to our fairytale.

At this point, the capitalist has a brand new bread factory and his $10 back which, after paying making his interest payment for the day, totals $9. He then hires his five bakers once more at $1 each and bakes another giant loaf. If this loaf were allowed to go directly to market a deflation would result and he would only get $5 for the loaf – with each worker getting a 20% share. This is because the same capitalist, since he already has his factory built, no longer needs to hire the five builders and so only the five bakers are employed. If there were no other actors in the economy these builders would remain unemployed and the aforementioned deflation would result. However, Roosevelt II has just been elected and, being the clever president that he is, he deficit spends to hire the builders to build a road in front of the bread factory – paying the minimum rate of $1 per worker.

At the end of the working day, the builders once more join the bakers at the factory door and, since everyone has received their wages, the bread sells at its previous rate – the capitalist gets $10 (after interest payments he has $9), the workers all get a 10% share of the giant loaf and there is no deflation. This time, however, the capitalist ends up with a tangible profit because the government has taken over the task of investment.

Once again, we must stop for a moment to examine what is going on here. It has now become clear where these profits are coming from: investment. Previously the capitalist was investing in his bread factory and this was generating wages that he would then take in as income. But now that his factory is built he need not spend any more money on investment so the government steps in and invests instead and this money returns to the capitalist as a tangible gain.

The key point here is that investment creates profit. We shall deal with this in more detail later on.

Everything on the magical wizard island is going well. The workers are fed, they’re voting in the right man who is keeping them employed and the capitalist is making healthy profits. But then Nixon II seizes power in a coup and, having to face an election to solidify his reign constitutionally, he ramps up deficit spending. The builders are taken off working on the roads and are drafted into the military to ensure discipline and loyalty. To quell any discontent they have their wages increased from $1 to $2. When all the workers turn up at the factory gates, the builders-turned-soldiers have more purchasing power than the bakers and they get a bigger share of the loaf – the bakers now only get a 6.66% share while the soldiers get a 13.3% share.

The capitalist, however, ends up with $15 for the loaf as there has been a general inflation due to the increase in the builder-cum-soldiers’ wages. He is delighted to have pocketed $10 of profit from an outlay of only $5 – he has effectively doubled his profit. Where it was only $5 under Roosevelt II, it is now $10 under Nixon II.

However, his joy proves short-lived. The bakers turn up the next day demanding wage-increases to match the soldiers so that they can have a fair share of the giant loaf. If the capitalist doesn’t comply the workers will go on strike or seek work from the government. The capitalist thus has to meet the workers demands and pay them $2 per head. So, he loses his extra profit, they consume as they did before and there is a 100% increase in prices and wages. The capitalist says that he’s going to take away his campaign contributions to Nixon II if he doesn’t curb the inflation, so Nixon II hires an economic advisor.

Before we move on we should take note of an important fact about deficit spending. In our simple model deficit spending was not necessarily a bad thing. Had Roosevelt II not undertaken deficit spending and road construction, half the workers would have been left unemployed and the economy would have suffered a general deflation, which would in turn have thrown business into disarray as the capitalist would have only broken even and been unable to meet his interest payments. The problems arose when Nixon II tried to use deficits as a political rather than an economic tool to please his would-be supporters. In doing so he continued to spend beyond the point of full employment and caused a general inflation (not to mention his wasting resources on a stagnant and useless military-industrial complex).

Although this is a crude model, the lessons transfer rather well to the real world. As a rule of thumb, deficit spending by a government is profit and job enhancing provided that the economy is not already operating at full employment – indeed, it is somewhat necessary. Beyond that point, however, a general inflation might occur with all the negative consequences that arise there from.
Now, let us turn to a slightly more realistic model of profits than the current simplified case. This is the ‘general case’ Kalecki model.

Kalecki’s General Theory of Profits – The Wonky Bit

When looked at closely what we have outlined above must come across as rather strange. The profits that the capitalist receives come from investment. Since these profits are then deployed to finance new investment – or, at the very least, are taken into consideration when taking on new financial obligations to fund new investment – we arrive at a strange loop, a sort of ‘snake eating its own tail’. As Kalecki himself put it in his ‘Studies in the Theory of the Business Cycle’ (p. 46):
“It may sound paradoxical, but according to the above, investment is financed by itself.”

So, when the capitalist himself funds this investment the profits he receives are merely his own funds washing through the system and coming back to him. Of course, he receives his capital assets (in the above example his ‘bread factory’) as compensation for his entrepreneurial efforts. But although these new real productive assets are created through the profit cycle, no new financial assets are created. That only occurs when the government steps in with its budget deficit or some other exogenous force enters our island economy.

The above model is perhaps one of the most powerful and the most pertinent for thinking about the sources of profit. However, it is a little too simplified. It makes assumptions that simply cannot be held up in the real world. It claims that workers do not save and capitalists do not consume. Both these assumptions are undoubtedly false. In order to rectify this we need to move from this simplified model, to Kalecki’s general model. (I take what follows from Professor Bill Mitchell’s excellent blog on the topic, ‘Why Budget Deficits Drive Private Profit’ which goes into this topic in greater detail than I do here).

Kalecki’s general model reads as follows:

Pn = I + (G – T) + NX + Cp – Sw

Pn = total profits after tax. I = gross investment. G = government spending. T = total taxes. (So, G – T = the total government budget deficit). NX = net exports (total exports minus total imports). Cp = capitalists’ consumption. And Sw = total workers’ saving.

So, in English that equation reads as follows:

Profits – Tax = Gross Investment + Government Deficit + Net Exports + Capitalists’ Consumption – Workers’ Saving

Phew! Now that we have a grasp on that we can move to summarise our findings and try to draw some conclusions.

What Determines Profit?

Profits are determined, to a large, extent by expectations of future gains. That may seem unusual but consider what has been laid out above. Profits, as we know, come from investment and most investment comes from the private sector. Thus, capitalists will be more inclined to invest if they think they can reap future gains. Profits are, in this sense, something of a self-fulfilling prophecy.
Most importantly, as Keynes always pointed out, there is an element of fundamental uncertainty here. Investment is heavily reliant on capitalists’ perceptions of future gains. If the capitalist does not see a market for his products – as happens when spending power (aggregate demand) is too low in the economy – he/she will be reluctant to invest. This, in essence, is how a lack of spending power might drag an economy in a depression or protracted recession. (It is also, of course, precisely what is happening in many countries around the world today).

Consider our original example. When the capitalist laid off his five builders after they had completed his bread factory they lost all their spending power. If they had continued to go unemployed the capitalist would have taken large losses, as he would have only had five rather than ten workers to sell his bread to. He would, in short, have incurred a rather substantial loss. If this had occurred we might predict that the capitalist would have gone bankrupt as his capital was slowly drained away through interest payments and so would not have engaged in future investment. Profits in the total economy of the magical wizard island would have fallen to zero and unemployment would have risen to 100% as the bread factory was taken over by the bank. Every resource on the island would have lain idle.

However, as we recall, the government stepped in and, by running deficits by spending without collecting taxes, hired the five builders so that the level of profitability remained constant. We can then predict that the capitalist would have gone on to further investment. He might have opened a jam factory and employed immigrants. As investment expand so too do profits – and with them, employment and living-standards.

Now, I can already hear the inevitable Austrian chime in. “Arg! You lying Keynesian totalitarian scum! The government didn’t need to invest to employ those five workers; another capitalist could have done so. You’re just a crypto-communist who wants the government to control our lives and tell us what to do! You hate freedom and liberty, ahhh! <3 Ayn Rand 4eva!”.

Our Austrian friend would, of course, be quite correct. The government would not have been required to step in had another capitalist migrated to our island and opened a new industry. And the government would never need to step in were this process to continue ad infinitum. The argument against this – although I don’t want to get too far into it – is twofold.

First of all, Austrians who make this argument are utopians. They tend to view the world in terms of how they imagine it could be, rather than as it is. The fact is that capitalist economies are inherently unstable and unemployment and deflation are always lurking around the corner. Capitalists don’t generally step in to fill in the gap. In fact – bipolar creatures that they are – they tend to run at the first signs of trouble and cause crises (Keynesian uncertainty again). The 19th century, when government intervention was limited, was a time of great instability and myriad financial crises. We have, thankfully, left this world behind us and, to be frank, we would not be able to return to it even if we wanted to.

Secondly and tied to this, is the fact that modern capitalist economies do operate with a fairly large government sector (not quite as large as in our simplified example, but close enough). Austrians will blame this on ‘evil’ people and ‘bad’ elements in society and claim that were these dastardly fiends not listened to, we’d all live in a pure capitalist utopia. Such a view of history is nothing short of paranoid – indeed, it’s a close approximation to how the Stalinists used to rewrite events to show that any bumps on the way to Communist utopia were due to ‘counter-revolutionaries’ and ‘subversives’. Far from a liberating view of the world, such utopian discourses are quasi-religious in their make-up. Were they ever taken seriously they would probably put society on a short road to totalitarian tyranny, as paranoid utopian politicians blamed every instance where the world refused to conform to their idealised view of it as being the result of a subversive Keynesian plot.

Anyway, back to our discussion. Aggregate demand can also come from other sectors. If we look at the Kalecki equation above we see that current account surpluses would also lead to aggregate demand; workers could be employed in the exports sector. This is an important point. But from the standpoint of policy, governments have limited control over how much a country exports and how much it imports. Governments can certainly influence this – through trade tariffs, exchange rate manipulation etc. – but they have no direct control over the external sector. They do, of course, have direct control over their budgets and this is why we emphasise this aspect.

(MMT aficionados will recognise the sectoral balances model of aggregate demand – which I dealt with in this discussion. Indeed, this is where the sectoral balances approach ‘plug into’ the Kaleckian profits approach. While the sectoral balances approach shows how spending in the economy is distributed, the profits approach demonstrates the ‘engine’ through which this is applied to economic development).

We will ignore capitalists’ consumption – that is: the amount that capitalists spend on goods and services because it is rather uninteresting. But note should taken regarding workers’ savings.
Saving by workers affects aggregate demand adversely. When a worker saves money he or she is not spending it and this discourages capitalists from investing. This is contrary to mainstream theory which, being unable to understand the sources of profits, assumes that workers’ savings lead to investment. Mainstream economists believe, erroneously, that capitalists borrow out of a pool of workers’ savings (Bill Mitchell deals with the ‘crowding out’ theory in the following blog). This is simply not the case in a modern economy and our discussion leads us to the exact opposite conclusions: all else being equal, workers’ savings lead to less potential for profitability. Of course, if workers go into debt (i.e. ‘negative savings’) they will certainly spur aggregate demand and lead to an investment boom. The 1990s and early 2000s ‘goldilocks’ economy – as discussed in my article linked above – shows how such a process might come about and its consequences.

Conclusion

As we can see, profits actually come from some fairly unusual sources. Government spending up to the point of full employment actually increases profits, while workers’ savings diminishes them. This ties into the MMT argument that government should offset workers’ desired savings. As we can clearly see from the contemporary situation, this happens in an almost automatic manner; as the private sector saves and pays down debt in the current uncertain environment, the government goes into deficit in order to float profitability.

We should also note that capitalist economies are not perpetual motion machines. Many people seem to have a vague inclination that capitalist economies are somehow ‘self-generating’ and, for example, that government spending or private debt-financing are exogenous or external factors. This is clearly not the case. Money enters the economy through either government spending or private sector indebtedness. These then wash through the economy and eventually turn up as profits. These facts need to be front and centre when public policy is considered.

Now that we understand the basic dynamics of profit in a capitalist economy we can explore a number of different issues; including: monopoly profits and financial profits and the role of profits in a financial crisis. With our basic understanding we will be able to investigate these in more detail in later pieces.

This post originally appeared at naked capitalism and is reproduced here with permission.