"Suum cuique" [To each his own, to each according to his merits.] ~ Latin proverb
The Profit Mechanism in a Free Market
Column by Cristian Gherasim.
Note: Cristian Gherasim plagiarized this column from here.
When a firm's revenue is greater than its costs, that firm earns a profit. When a firm's costs are greater than its revenue, that firm suffers a loss. Fair enough. But what do profits and losses mean? Are they the product of blind chance? What useful information can possibly be contained in profits and losses?
Contrary to public opinion, profits do not embody "exploitation" of laborers or customers. Profits embody information in the form of a lucrative reward for the entrepreneur or capitalist who is able to combine labor, capital goods, and other inputs in such a way as to produce an output that consumers value more highly than they value the inputs in another configuration. In plain English, the Coca-Cola Company earns profits because people are willing to pay a dollar for a two-liter bottle of Coke that may only cost 90 cents to produce. Profits are the rewards enjoyed by Coca-Cola for producing a product that people want to buy at a price they are willing to pay.
Just as profits reward producers for making things people want to buy at prices they are willing to pay, losses punish producers for producing things people don't want at a cost consumers are not willing to cover. Losses are the market's way of punishing producers for wasting resources. Those who sustain losses long enough will grow tired of being slapped around by the invisible hand and will eventually remove themselves to somewhere they will cause no further damage.
This sounds harsh, but let's illustrate with an example. Suppose that your friend John comes up with a crazy idea of making salty ice cream. Most of us would expect that the product would bomb completely, and your friend would be sitting with unsold inventories of John’s Super Ice Cream. To produce the ice cream, John needed salt, milk, fruit, ice cream cones, time, labor, and capital. The losses he suffers are the market's way of telling him that he has wasted salt (which might be better used to make salt-and-vinegar potato chips), he has wasted milk (which might be better used to make…chocolate), and so on.
It may very well be that John just hit a patch of bad luck and, after disposing of his inventory (which he might have to pay someone to take), John might hit the big time with a different kind of Super Ice Cream. If he fails again (say by producing instead Mustard Ice Cream), he will eventually find himself pushed by the invisible hand into an occupation where he can use his powers for good.
Profits and losses ensure that in a market economy, resources are allocated to their highest-valued uses by rewarding those who create wealth and by punishing those who destroy it. Contrast this with what would take place under a centralized system where there are no profits and losses. In his short book Economic Development, John Kenneth Galbraith (who in many ways embodied and popularized the Keynesian consensus of the late 20th Century, and who was a great proponent of economic planning) offers as an example a conspicuous entrepreneurial failure by the Ford Motor Company. According to Galbraith, "great outlays were made on the theory that the public wanted a very large vehicle with something of the physiognomy of a surprised frog." Galbraith goes on to say that if Ford Motor Company were a state-owned corporation, future incarnations of their automobiles would likely have to pass an inspection by a centralized Board of Automotive Aesthetics or something similar. Given that there is no universal standard as to what constitutes an aesthetically pleasing vehicle, it would be literally impossible for the board to reach a conclusion. There's no way to "solve" the problem of producing the ideal vehicle, but in a market economy, there is room for all of us.