Chapter 4: Profits: The Consumer's Best Friend

Few economic concepts are as misunderstood as profits. The common view is that firms increase profits at the expense of consumers. It seems plausible that firms' profits rise when they charge higher prices, so there must be a conflict between the well-being of consumers and the profitability of firms.

The truth is that profits are the consumer's best friend. The most effective consumer protection policy is one that allows firms to make as much profit as possible (without the help of government protections or subsidies). Profits are the most effective means consumers have of communicating their preferences to firms.

Consumers will reward a firm with a profit only if the firm is using resources to produce the goods consumers value most. If a firm uses resources to produce less value than other firms could produce with the same resources, consumers will punish that firm with a loss and reward the other firms with profits. This allows the firms providing the most value to expand production by bidding resources away from firms providing less value.

Furthermore, consumers' ability to reward some firms with high profits and punish others with low (or negative) profits results in lower prices. Indeed, firms with the highest profits often charge the lowest prices.

Profits and Motivation

To understand the role of profit, we first have to know what it is. Profit is the difference between the revenue received from producing and selling goods and services and the cost (always opportunity cost) of the resources used to produce them.

The owner (or owners) of a firm is vitally interested in how much profit it makes; the more the better. In small firms, the owner decides directly what to produce, how much to produce and how to produce it. Economists refer to these owners as residual claimants because they have a legal claim on the firm's profits, or the residual between revenue and cost.

In large corporations the residual claimants are the shareholders, who are so numerous that instead of making corporate decisions themselves, they hire managers to run the firm. But even here, tying management pay and tenure to the company's stock performance can motivate managers to act like residual claimants by encouraging them to make profits as large as possible.

So while profits may seem like an extra cost to consumers, profits actually lower prices by motivating firms to produce the right products, in the right amounts, as cheaply as possible.

Consider what occurs when there is no residual claimant. Government agencies don't make a profit; they receive appropriations at the beginning of each fiscal year. Any money not spent at year's end goes back into the general fund, and the agency may get a smaller appropriation the following year. To avoid this, managers will desperately search for something to spend excess money on—more computers, travel, office space, anything—regardless of whether it adds to the value of the service provided.

The result is that the cost of providing government services is much higher than it needs to be, and citizens pay far more in taxes than they would if the services were provided efficiently. Obviously, the residualclaimant owner of a business would never panic at the prospect of revenues exceeding cost and waste the difference. Instead, the owner constantly looks for ways to reduce costs and thereby increase profits.

Lower Prices
While finding ways to reduce costs increases profits, it will generally not do so for long. Much of the cost decrease will be passed on to consumers in lower prices, since a firm's long-run profitability depends on meeting or beating the competition.

Even if a firm ends up with lower costs than its competitors, it can still find it profitable to pass some of the cost savings on to consumers to increase its market share. A small price decrease can attract a large increase in customers. But in the longer run, firms either match the cost decreases of rival firms or go out of business. So most—and often all—of a cost reduction is soon passed on to consumers through lower prices. The only way a firm can hope to maintain higher than normal profits is by continuously cutting costs faster than its competitors.

Innovation
The competition for higher profits also motivates firms to develop new products. For example, personal computers, and the many products made possible by the miniaturization of electronic circuits, now provide benefits to people that science fiction couldn't anticipate a few decades ago. The cost of developing and producing new products is often very high, but doing so can be profitable because a few wealthy people will pay big bucks to possess hot new products.

Fortunately for those of us who aren't rich, the desire for profits causes the price of innovative products to start falling and soon become cheap enough for almost everyone to afford.

It should not be surprising that falling prices result from firms competing for higher profits. After all, there will never be more than a relatively few extremely rich people. So selling only to the rich is not the best way to make large profits.

The most successful firms are those that figure out how to reduce the cost of goods and services so that the masses can afford them. Andrew Carnegie did it with steel, John D. Rockefeller with oil, Henry Ford with cars, Richard Sears and Sam Walton with retail stores. Michael Dell is doing it with computers and Bill Gates with software.

No matter how successful a business, or how rich its owners, most of the benefits from profitable firms go to consumers in the form of better products at lower prices. Profits motivate producers to anticipate and cater to the desires of consumers and enable consumers to transfer more resources to the firms doing the most to enrich their lives.

Profits also allow consumers to impose discipline on producers, making possible the freedom firms need to research and innovate. The result is constantly improving goods and services and ever-lower costs. The connection between discipline and freedom is the topic of the next chapter.

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