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BASIC CONCEPTS, CORPORATIONS AND FINANCIAL MARKETS , THE MARKETPLACE
Profits
By Lester C. Thurow

Categories: Basic Concepts Corporations and Financial Markets The Marketplace
By Lester C. Thurow,
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n a capitalistic society, profits—and losses—hold center stage. Those who own firms (the capitalists) choose managers who organize production efforts so as to maximize their income (profits). Their search for profits is guided by the famous “invisible hand” of capitalism. When profits are above the normal level, they attract additional investment, either by new firms or by existing firms. New investment enters until profits are competed down to the same level the investment could earn elsewhere. In this way, high profits attract firms to invest in areas where consumers are signaling that they want the investment to occur.
Capitalists earn a return on their efforts by providing three productive inputs. First, they are willing to delay their own personal gratification. Instead of consuming all of their resources today, they save some of today’s income and invest those savings in activities (plant and equipment) that will yield goods and services in the future. When sold, these future goods and services will yield profits that can then be used to finance consumption or additional investment. Put bluntly, the capitalist provides capital by not consuming. Without capital much less production could occur. As a result, some profits are effectively the “wages” paid to those who are willing to delay their own personal gratification.
Second, some profits are a return to those who take risks. Some investments make a profit and return what was invested plus a profit; others do not. When an airline goes broke, for example, the investors in the airline lose some of their wealth and become poorer. Just as underground miners, who are willing to perform a dangerous job, get paid more than those who work in safer occupations, so investors who are willing to invest in risky ventures earn more than those who invest in less risky ones. On average, those who take risks will earn a higher rate of return on their investments than those who invest more conservatively.
Third, some profits are a return to organizational ability, enterprise, and entrepreneurial energy. The entrepreneur, by inventing a new product or process, or by organizing the better delivery of an old product, generates profits. People are willing to pay the entrepreneur because he or she has invented a “better mousetrap.”
Economists use the word “interest” to mean the payment for delayed gratification, and use the word “profits” to mean only the earnings that result from risk taking and from entrepreneurship. But in everyday business language the owner’s return on his or her capital is also called profits. (In business language the lender’s return is called interest, even though most lending also entails some risks.)
Attempts have been made to organize productive societies without the profit motive. Communism is the best recent example. But in the modern world these attempts have failed spectacularly.
While most profits flow to the three previously mentioned necessary inputs into the productive process, there are two other sources of profits. One is monopoly. A firm that has managed to establish a monopoly in producing some product or service can set a price higher than would be set in a competitive market, and thus earn higher-than-normal competitive returns. (Economists call these extra returns “economic rents.”) Historically, one can find examples of monopolies that have been able to extract large amounts of income from the average consumer. One modern example is taxicab companies, which in virtually every major U.S. city outside of Washington, D.C., have persuaded the local government to limit the number of cabs that may legally be operated.
Although some monopoly profits exist in any economy, they are a very small portion of total profits in any rich society. In rich societies, most consumption consists of either luxuries or products that have close substitutes. As a result, the twentieth-century monopolist has less power to raise prices than the nineteenth-century monopolist. If the monopolistic firm does raise prices very much, the consumer simply buys something else. Professional football, for example, is a monopoly. But Americans have many ways to get pleasure without watching football. The National Football League, therefore, has some, but not much, power to raise prices above the competitive level.
“Market imperfections” provide a second source of profits. Suppose firm A sells a product for ten dollars while firm B sells the same product for eight dollars. Suppose also that many customers do not know that the product can be bought for eight dollars from firm B and, therefore, they pay ten dollars to firm A. Firm A gets an extra two dollars in profit. In a “perfect” market, where every consumer is completely informed about prices, this would not happen. But in real economies it often does. We all recall buying a product at one price only to find later that someone else was selling it for a slightly lower price. Profits from such “imperfections” certainly exist, but here again they are not a large fraction of total profits.
When it comes to actually measuring profits, some difficult accounting issues arise. Suppose one looks at the income earned by capitalists after they have paid all of their suppliers and workers. In 2004 this amounted to $3,689 billion, or 31 percent of GDP. Some of this flow of income represents a return to capital (profits). Some of it needs to be set aside, however, to replace the plant and equipment that have worn out or become obsolete during the year. It is hard to say exactly how much must be reinvested to maintain the size of the capital stock (“capital consumption allowances”) because it is hard to know precisely how fast equipment is wearing out or becoming obsolete. But the Department of Commerce thought that $1,352 billion needed to be set aside to maintain the capital stock in 2004. This left $2,337 billion for other purposes.
Many capitalists are small businessmen (technically known as single proprietorships) whose “profits” include their wages. No one knows how to disentangle these two streams of income. In the corporate sector, where this problem does not exist, profits after subtracting capital consumption allowances amounted to $985 billion, or 14 percent of the GDPs produced in the corporate sector. Some of these profits, however, were paid to the government in corporate income taxes. After the payment of taxes, $716 billion, or 10 percent of the corporate GDP, was left as profits. Of this sum capitalists paid themselves $444 billion in dividends and put $272 billion back into their businesses as new investments.
Table 1 provides some information on profits in different industries. In 2005 the highest profits were earned in toiletries and cosmetics (41.4 percent), the lowest in electronics materials (−1.3 percent; i.e., losses rather than profits). Over time, profits rise and fall with the onset of booms and recessions (see Table 2). After tax, corporate profits for nonfinancial corporations have ranged from above 9 percent of the GDP produced by nonfinancial corporations in 1978 to just above 3 percent in 1986. Profit rates fell in the recession of 1990–91 only to rise again in 1992. They fell again in the recession of 2000 and recovered in 2002. No matter what the year, corporate profits as a percentage of GDP are far below 45 percent, the level, according to a Gallup poll, that many college graduates believe them to be.

Table 1 Return on Stockholders’ Equity, 2005 (selected industries, percentage)
Toiletries and cosmetics41.4
Beverages (alcoholic)32.6
Tobacco32.1
Beverage (soft drinks)26.2
Building materials22.9
Food processing21.2
Pharmaceutical18.3
Petroleum (producing)16.9
Petroleum (integrated)15.5
Computer software13.8
Medical services13.0
Computers and peripherals12.7
Publishing12.3
Chemicals (specialty)12.3
Apparel12.0
Auto parts11.4
Automobiles and trucks10.0
Furniture and home furnishings9.9
Machinery9.3
Metal fabricating9.2
Trucking9.0
Aerospace and defense8.9
Metals and mining8.5
Chemicals (basic)8.2
Forest products2.5
Tire and rubber products2.0
Precision instruments−0.2
Electronics−1.3
Value line market11.6
The mid-1980s saw a steady decline in profits as firms acquired tremendous debt in the merger and takeover wars. Profits reached a low of 3.1 percent in 1986. Because the owners were effectively withdrawing their own capital from their businesses (substituting debt for equity), they were providing much less of the total capital stock and, therefore, earning less in profits. Profits went down as interest payments to lenders went up.

Table 2 After-Tax Profits as Percentage of GNP for Nonfinancial Corporations, 1970–2004
19705.619807.519904.620004.8
19716.219816.819914.320013.8
19726.819825.019925.120024.3
19737.919835.319935.720035.2
19748.319845.619946.720045.1
19757.819854.419957.2
19768.619863.119967.4
19778.819874.519977.5
19789.119885.619986.2
19798.919894.719995.8
Source: U.S. Department of Commerce, Survey of Current Business.
Capitalism requires profits, and profits require ownership. Property ownership generates responsibility. Two decades ago I wrote an article about communism entitled “Who Stays Up with the Sick Cow?” Without ownership the answer was too often, “No one,” and the cow and communism died.
About the Author
Lester C. Thurow is the Jerome and Dorothy Lemelson Professor of Management and Economics at MIT’s Sloan School of Management. In 1977 he was on the editorial board of the New York Times. From 1983 to 1987 he was a member of the Time Magazine Board of Economists. Shortly after graduating from Harvard, he was a staff member with President Lyndon B. Johnson’s Council of Economic Advisers.
Further Reading
1921. Knight, Frank. Risk, Uncertainty, and Profit. Boston: Houghton Mifflin, 1921. Available online at: http://www.econlib.org/library/Knight/knRUP.html
Thurow, Lester. “Who Stays Up with the Sick Cow?” New York Times Book Review, September 7, 1986, p. 9.
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RELATED CONTENT By Amit Varma
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