Profit Theory in Neoclassical Economics

More on heterodox economics:

Profits and Loss, by Daniel Davies, Crooked Timber: ...A large part of my interest in heterodox economics derives from one major problem with neoclassical economics. In my opinion, it’s a big enough embarrassment to the profession that somebody ought to have done something about it.... I’m ... prepared to tentatively advance this “anomaly” in neoclassical economics as being constitutive of the difference between orthodox and heterodox economics, as currently practiced.

The anomaly I’m talking about is that neoclassical economics, in both macro and micro forms, nearly invariably works on the basis of models in which there are no profits.

Since in general, companies do earn profits, I think this is a pretty big problem.

Let me add a couple of caveats. Neoclassical economics does allow for “normal profits”, meaning a sufficient surplus of income over expense to repay the cost of financial capital... But this isn’t really profit at all, and it doesn’t describe economic behaviour at all well – firms which are merely earning their cost of capital certainly don’t in general think that they’re doing as well as can be expected with no room for improvement.

Neoclassical economics also allows for monopoly profits to be earned in situations in which there are legal or practical barriers to entry into industries. In fact there’s practically a cottage industry within economics in making funky little models of information asymmetry in which monopoly rents of one sort or another arise. ...

But this really doesn’t describe much of the economy either; there are actually very few genuinely monopolistic firms and even in completely commoditised industries, there are often significant profits made and significant variations in the profitability of companies within the same industry. In any case, if we were to assume that monopoly rents were the norm for the economy, then this would be curtains for a lot of the conclusions of orthodox economics – taxes, wage regulations and even tariffs could not be presumed to have the effects that they are normally assumed to have. ...

So that’s what I’d take to be definitive of heterodox economics today – it’s the branch of economics that starts from the assumption that the rate of profit for the economy as a whole is determined otherwise than by a natural tendency toward the factor price of capital. In other words, in the current state of play in economics, it is heterodox to take profits seriously. ...

Tyler Cowen adds:

Why are there no profits in economic theory?, by Tyler Cowen, Marginal Revolution: Shouldn't CrookedTimber be the site that covers the heterodoxy?  Daniel Davies... Do read his caveats.

I usually answer such questions by referring to the ordinary humdrum of my suburban life.  It took my three days to buy the new Paul McCartney CD...  And can you guess why it took me so long?  The CD is available only in Starbucks, but until today each Starbucks was situated so that my exit would have necessitated a left turn across four lanes of crowded traffic (and, most importantly, without a traffic light).  I love "Maybe I'm Amazed" as much as the next guy, but this boy just ain't up for those sorts of indignities.

The higher the value of time, the more likely these competitive barriers will arise.  So the standard monopoly model explains much more of the economy than most market-oriented economists like to admit.  That said, I am less sold on Davies's worry that this has nihilistic consequences for mainstream economics.  Tariffs are still usually bad; let's not forget that behavioral imperfections plague politics as well.

And Alex Tabarrok weighs in with:

Profits and Losses, by Alex Tabarrok. Marginal Revolution: Daniel Davies thinks that it's a point in favor of heterodox economics that neoclassical economics assumes profits are zero ("normal") while profits in the real world are not zero. Tyler says the explanation is market power.  I think both are mostly wrong.

Take a look at the national income accounts.  ...  In a generous accounting true profits might be 5-10% of gross domestic income - not zero but not very large either.  Indeed, 5-10% is an amazingly low figure when one recognizes that the entire capitalist economy depends on the existence of profits. 

Is the explanation for profits monopoly power?  Not really.  Or rather, the better way of phrasing it is that most profits are a return to innovation and entrepreneurship.  Innovation and entrepreneurship typically bring some market power but disequilibrium monopoly has very different implications for policy than equilibrium monopoly. 

Here's some intuition.  Textbook neoclassical economics says profits and losses are zero. The standard monopoly story can explain profits but not losses.  The return to entrepreneurship/dynamic economy/creative destruction story that I am telling can explain both profits and losses. 

Thus Davies is correct, profits do suggest a role for heterodox economics but it's not the paleo-Keynesian/Marxist heterodoxy that gets the boost but the Austrian heterodoxy of Mises, Hayek and Schumpeter.

There's a literature on this, and I think the challenge has been partially answered by Knight who notes that profit can exist as compensation for uninsurable risk, and also earlier by several writers who noted that profit can exist in the dynamic transition between equilibrium points.

But instead of reinventing the wheel, let me turn the discussion over to Landreth and Colander in their History of Economic Thought:

Profit Theory Although the classical economists had applied the term profits indiscriminately to all the income of the capitalist-entrepreneur, they did recognize that this income was a payment containing at least three distinct elements: a payment for the use of capital, a payment to the entrepreneur for management service rendered, and a payment that compensated for the risks of business activity. Payments to the firm for the use of capital (assuming that this payment involves no risk) fall under the modern classification of interest, which we will discuss in the next section.

Can we identify entrepreneurship as a fourth factor of production, defining the marginal product of the entrepreneur as the measure of his or her contribution to the firm for management services and assumption of risk? J. B. Clark was the most important early developer of marginal productivity theory to recognize that this solution is not satisfactory. The return to the entrepreneur as a manager is not profit, but a wage. Profit-or, to be more exact, pure profit-must be defined as a residual remaining after all the inputs used by a firm are paid a price equal to their opportunity cost. Perfectly competitive markets in long-run equilibrium result in all factors' receiving the value of their marginal product, which is also equal to their opportunity cost. Assuming a homogeneous production function, these payments are costs of the firm and when subtracted from total revenues yield a zero rate of profit. The existence of profit must then be explained as a consequence either of competitive markets' not being in long-run equilibrium or of actual markets' not being perfectly competitive.

Long-run competitive equilibrium is, of course, a theoretical construct to which no market ever conforms. Let us keep the competitive assumption, however, while analyzing the emergence of profit in a market or an economy that is not in long-run equilibrium. When businesses buy inputs to produce an output, they assume risks. The final price of the output must be estimated, and the price of and payments to the inputs become contractual obligations. If the total revenues of the firm exceed the payments to the inputs, profits accrue; if revenues are less than payments, losses occur. Profits in perfectly competitive markets might, then, be explained as the result of disequilibrium occurring while the economy moves to a new position of long-run equilibrium.

An explanation of profits as temporary income resulting from dynamic changes in the economy was suggested by J. B. Clark, Alfred Marshall, and J. A. Schumpeter. Assume that an economy is in long-run equilibrium, with all factors receiving a return equal to their opportunity cost, and that the revenues of a typical firm are equal to its costs. A change in consumers' preferences or a change in technology will lead to profits in some industries. These profits will be eliminated, however, by competitive forces as capital moves to those markets having above-normal rates of return. Thus, profit is not a return to a factor of production but a windfall associated with dynamic elements in an economy.

F. H. Knight (1885-1972) significantly integrated and extended prior theories of profit by combining in one theory the factors of risk, managerial ability, and economic change. In Risk, Uncertainty, and Profit, Knight distinguished between risks businesses take that can be insured against and risks for which no insurance is available. A firm, for example, may lose its plant through fire, but actuarial knowledge permits this risk to be covered by insurance. The insurance premium becomes a part of the firm's costs. This kind of risk is therefore not a source of profit. Profits exist because there are uncertainties in the market that are not insurable. These arise from dynamic changes in the market. However, if we drop the assumption of perfect competition, profits may arise for a number of reasons, the most important being monopoly or monopsony power.