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The Present State of Profit Theory: Asset or Liability?

Mises Daily: Saturday, May 31, 2008 by

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Louis M. Spadaro
Louis M. Spadaro (October 11, 1913 – May 3, 2008)

[This article was first published as a pamphlet in 1963 by the Intercollegiate Studies Institute. It appears online for the first time here on Mises.org.]

Introduction

One of the main tasks of economic theory is to explain the function of each of the productive agents or "factors" in the economic process and thus try to discover the principles according to which each earns a return out of the total output of that process. This has long been recognized; indeed, David Ricardo centered his analysis on it in the conviction, as he put it, that "to determine the laws which regulate this distribution is the principal problem in political economy…." Nor was it merely an academic problem; then as now the division of the national product was rooted in a host of practical problems, political and ethical as well as economic.

There has ensued an enormous amount of theorizing and controversy around this problem of "distribution," and the end is still not in sight. It is true that some considerable progress has been made, particularly in identifying the relevant issues and basic relationships. But whatever progress has been achieved has been singularly uneven as among the several productive factors and their respective shares. The theory of profits has remained the least decisive and therefore the least convincing part of distribution theory; it is the purpose of this paper to explore some of the possible reasons for this in the hope that further efforts may gain from the inquiry.

In passing, it is hardly necessary to point out that the ambiguities in our theories about profits can have serious consequences in practice. Witness the current tendency to downgrade the importance — even the respectability — of profits as earnings evidenced not only in popular discourse but in our tax laws and in our policies with respect to consolidations, prices, wages, and the like. Nor is the ultimate cost limited to the earners of profits; continued vacillations of policy toward profits, when added to the irreducible uncertainties within which business must operate in the real world, may make for an increasingly inclement, perhaps intolerable, climate for survival of a free economic society.

On reflection, four types of contributory cause suggest themselves to account for the unsatisfactory state of profit theory. The first two have begun recently to attract more professional attention and need only be mentioned here; the last two are directly germane to the argument of this paper.

Firstly, almost all discussion of profit, whether in the political forum, over the bargaining table, or in the classroom, labors under the burden of a surprisingly large set of preconceptions and even misconceptions about the subject. To mention but a few, the competitive nature of profits, the diffusion of profit earners, the relative size and stability of profits, and the existence and frequency of losses are matters about which there is wide and uncritical acceptance of half-truths and even outright fallacies. Even professional economists are not always immune to this "folklore"; elements of it creep into economic models by way of unspecified or unverified assumptions. Fortunately, attempts to correct this have already begun to be made.[1]

Secondly, the concepts of profit used by accountants for the special purposes of their work have generally failed to correspond exactly with those of economic theory. This appears to be due for the most part to the fact that profit, like the other concepts used in accounting procedures, is tailored to fit the conventions on which accounting — essentially a tautology — is necessarily based. These conventions — which correspond, in the language of the economist, to simplifying assumptions — were, unfortunately, rarely made explicit by the accounting profession, with the result that their distortive effects on ultimate explanation went largely unrecognized and therefore not taken into consideration by economists who attempted to use accounting profit either as empirical data or as a formal concept. In either case, the economist was bound to be misled. On the one hand, the calculations of profit made by accounting are not able, logically and of themselves, either to confirm or falsify propositions of a strictly economic character. On the other, and for precisely the same basic reason, accounting concepts of profit are not at all formally admissible in economics; they do not answer the kind of questions an economist is concerned with, for the reason that they are designed only for the provision of answers within a rigidly delimited and tautological framework. Recently, the implications of the concept of income as used by the accountant have begun to be studied explicitly and systematically;[2] although these lie outside the scope of this essay, their results already promise not only classification of the degree to which accounting and economic concepts can be expected to mesh, but also a number of useful new insights into the nature of income which, if incorporated into economic analysis, should enable the latter to deal more imaginatively with some of the problems we shall discuss later on.

Thirdly, the failure of economic thought to define in an unambiguous way either the identity of profits as an independent share of income or the economic "function" provided by the agency receiving that share has also had a number of deleterious results. During a substantial and earlier part of the relatively short history of economic analysis, what we now call profits were not treated separately but were variously regarded either as a wage return to labor of a special kind or as part of the general return to capital — an aggregate called, appropriately enough, the "profits of stock." As part of the subsequent effort on the part of economic theorists to differentiate profits from other factor returns, it was, of course, necessary to make a delineation of the specific and separable function of the profit-earning factor in the economic process which would be sharper than the largely intuitive and rather vague concept of the entrepreneur. Now the search for a definitive identification of this function has continued down to the present day; but it has been more impressive for its display of ingenuity on the part of a number of economists than for the production of any single and final solution to the problem. As a result, the best we appear to be able to do now-a-days is to present to the student of economics a lengthening series of alternative — and therefore tentative — "explanations" of profits.

Currently influential theories about the nature of profits alternatively describe them as the return to

  1. the initiators of innovations in the economic system;[3] or
  2. those who ultimately (and successfully!) bear the noncalculable and therefore noninsurable risks attending the economic process;[4] or
  3. individuals and firms whose monopolistic market position enables them to establish and maintain a measure of noncompetitive gains.[5]

It is important to note that each of these views is emphasized over the others by a largely different group of economists, that it reflects significantly different views about the nature and the working of the economic system, and that each implies, in any translation of theory into practice, a different set of policy prescriptions and, indeed, different degrees of public intervention.

Moreover, the failure of economic theory to establish a cohesive underlying explanation of profits appears to feed on itself by acting as a deterrent to further search in at least two ways. On the one hand, the necessity of having to admit that contemporary profit theory is eclectic — that profit is, in the words of one noted economist, "a miscellaneous catchall category"[6] — leads to the inclusion, among the alternative explanations of profit,[7] the view that a large part of what is ordinarily called profit consists of implicit returns to the enterpriser for the use of his own labor, natural resources, and capital — a view that quite clearly begs the question at issue. On the other hand, because of the unsettled nature of profit theory, even the earliest wines of economic theory retain a surprising degree of potential headiness and tend to be offered again in new bottles.

Thus, the view of profit as the return to a special kind of labor is patently involved in the notion of a "managerial revolution" in corporate management. Again, an older identification of profits with the provision of capital is implicit in recent discussions about the propriety of treating as profits the returns to investment in common stock by the general public, who do not actively participate in decision making. It is interesting to note, in passing, that the argument of the last two examples cited, and of others like them, rests ultimately on their willingness to equate the nonexercise of a power with the nonexistence of that power.

In addition to the three foregoing elements contributing to the generally unsatisfactory state of the theory of profits, all of which have, in one way or another, come under discussion in the literature, there is a fourth which has curiously escaped detailed scrutiny and which it is the purpose of this paper to explore somewhat. It concerns what might be termed the analytical analogue of the inquiry into the economic function assignable to the profit-earning factor. The outline of what is here suggested as a possibly fruitful area of research would emerge, I think, if we imagine that economists, instead of asking how profits function in the real economic world, were to ask ourselves exactly what role we expect our theory of profit to play in our economic models.

This procedure of inquiry is, of course, more remote, more technical, and more restricted than discussions about actual profits usually are, or need to be. However, it offers the possibility of bringing to light the presence of any inconsistencies, weak assumptions, or other faults inhering in the concepts and the methods we use to construct our models. Here as elsewhere, attention to methodology hardly needs apology; it should by now be abundantly clear that errors — even compromises — made on this level not only tend to have a greatly magnified distortive effect when translated into real economic entities and relationships, but are often all but undiscoverable from the surface of things.

We shall argue, in what follows, that precisely this sort of distortion has been allowed to creep into our calculations of equilibrium in economics; more specifically that we have allowed, in the interests of theoretical neatness and determinacy, special and unverified assumptions concerning profits to go so long unchallenged that their dislodgement, if it proves to be necessary, will require a prodigious effort of revision and redirection. Accordingly, we shall first (section I) explore the relevance to our theories of profit of the allegedly "residual" nature of profits; then (II) attempt to determine the extent of, and the technical reasons for, our general reliance on the assumption of profit maximization; and finally (III) trace some of the implications of our subject in the real world of economic attitudes and policies.

I. The Allegedly "Residual" Nature of Profits

Despite their very great differences concerning the function which each assigns to the profit-earning agency, the various theories of profit exhibit substantial agreement that profits are, however they may be caused, essentially residual in character; that is, profits are what is left when all payments to all other factors of production have been made, or at least calculated. Most of these theories are seemingly content to try to "explain" why profits emerge and to leave the determination of their exact amount in any specific instance to this process of subtraction. And even in those theories of profit where the residual nature of profit appears on the surface to be more integrally a part of the explanation — as is the case with the Marxian doctrine of exploitation — closer examination reveals that here, too, the determination of the amount (or the rate) of profit requires recourse to assumptions lying outside the mechanism of explanation itself — in the Marxian case, the gratuitously introduced assumption seems to be the insatiability of capitalist acquisitiveness, which is directed at none other than the same residual share (or rate). In view of all this, it would therefore appear fair to summarize the present state of profit theory by saying that there has not yet emerged a complete explanation of profits — one capable, that is, of accounting within its own terms alone for both the appearance of profits and their magnitude; and that, as a consequence, the concept of profit as a residuum has had to be uniformly retained without adequate attention to the logical implications of this retention.

"A true residual is one whose magnitude is neutral; that is to say, it can be large, or small, or even zero without affecting the circumstances which produce it. This property of a residual is clearly at odds with every concept of profit in economics…"

At this juncture, several questions suggest themselves with respect to the present state of affairs. The first is, does the general acceptance of, and reliance upon, the residual nature of profits prove that there is, however dimly perceived at present, some fundamental explanatory value in this concept? Hardly; there are much more plausible and less mysterious reasons to account for the ubiquitousness and the persistence of the residual concept. For one thing, empirical observation of the order in which payments are actually made, under conditions of private enterprise, has always tended to lend credence to the view that profits are, in some sense, essentially a remainder. Now, while this is, of course, perfectly true and obvious, it has tempted the unwary, whether by analogy with arithmetic or for some other reason, into a corollary which is not true, but whose falsity is a little less obvious: that the size of the remainder is purely a passive result of the computation and in no way influences either the entities or the processes by which it is determined. For the profit remainder is, in this respect, very unlike its arithmetic cousin; it actively influences the process through which it is determined, so that a more cogent arithmetical analogy would be that of fixing a remainder and then setting the terms and procedures of the calculation so as to produce that remainder. This paper is concerned not with those who commit this error but with those who do not, but who may be led, as we shall see, in the next section, into the more subtle error of assuming that the remainder is always, and must be, made a maximum.

Another circumstance which lends support to the residual view of profits is the often misunderstood testimony of double-entry bookkeeping. In our accounting procedures profits are clearly and explicitly treated as residuals, a fact which appears to impress people in inverse ratio to their familiarity with the objectives and the detailed procedures involved. For this reason, the accountants themselves are much less apt to be deceived by this evidence than is the general public — the latter including a large number of businessmen and even some economists. For it should be noted, and is too seldom, that accounting makes no claim to explain profits, or, for that matter, any other income share. Its entire purpose is to represent in convenient and manageable form the configuration of standardized components in a given total at a point in time (as in the case of a balance sheet), or to trace the relative changes in these components over a period of time (as in an income statement). Its orientation is historical and descriptive rather than explanatory or predictive. Its method is, essentially, to start with a highly plausible tautology; for example, that total dollar sales equal total dollar purchases and goes on to examine shifts in the components within the constraint of this posited and necessary equality. In terms of productive factors, a firm is conceived of as having to pay out all of its receipts during a given period to the sum of cooperating factors; to do any less or more would deny the basic tautology on which it bases its deductive analysis. The resulting picture is highly useful for managerial decision making (which includes, let us be careful to note, decisions as to the adequacy of profit levels); but it is likely to mislead those who are prepared to see any special significance in the residual profit in accounting beyond the use of a borrowed concept to assure that the two general terms of the initial tautology maintain their necessary equality.

A third possibility is that profits, because they relate to the productive factor which was the last to be distinguished for the very reason that it was more difficult to explain than the others, quite naturally tended to be regarded as the unexplained variation remaining after the other factors had been dealt with and therefore amenable to identification by a process of elimination. But this is tantamount to merely assuming the residual nature of profits — an assumption admissible at best only as a tentative and exploratory device and whose validity depends on considerations raised by the second general question about residuals, to which we now turn.

"The measurement of profit, however, is not always prevented from affecting its explanation, with the result that there is some vacillation as to whether profits are a cause, or a result, or both."

This question is whether the treatment of profit as a residual involves us in inconsistency — either of a formal logical nature or with respect to other propositions made about profits. In the first place, a true residual is one whose magnitude is neutral; that is to say, it can be large, or small, or even zero without affecting the circumstances which produce it. This property of a residual is clearly at odds with every concept of profit in economics — even with that of Marx; indeed, it implies denying that there is a factor of production corresponding to this income. Secondly, apart from its magnitude, a complete residual is not, and cannot be, as such, a cause rather than a result; the line of causality should run not from the residual to other factors, but rather the other way. That is not to say that an entity which is essentially not a residual may not be calculated residually — especially where no better way is known, as appears to be the case with profits. But the process of measurement, it should be clear, has no necessary connection to explanation. A physician may measure the temperature of a patient in any one of a number of ways, but he does not assume that any of them offers any clue to the explanation of a fever, nor that a more accurate way of measuring is any better than a less accurate one for this purpose. The measurement of profit, however, is not always prevented from affecting its explanation, with the result that there is some vacillation as to whether profits are a cause, or a result, or both.

To put the matter differently, two related conditions must be satisfied if the residual concept is to be used validly and with precision:

  1. All components other than the residual must be completely specified, for only then will the process of elimination be valid. (Though even here the residual is not necessarily identified, i.e., what is left may include not only profits but also some other (fifth) factor not yet discovered.)
  2. It is imperative that the other factors be independent of the residual in the sense that the latter does not enter into the determination of any of the factors eliminated in arriving at that same residual. Failure to meet this requirement results in circularity whenever the process of elimination is used, since it amounts to assuming at least part of what has to be explained.

We shall argue in the next section that this last condition is systematically, though subtly, violated in our calculations of equilibrium in economics, and that this takes the form of undue reliance on the assumption that the profit residual necessarily and always tends to be maximized.

II. The Assumption of Profit Maximization

Even a casual reading of economic theory cannot fail to impress one with the fact that our reasoning depends to a very great extent — even crucially — on our being able to say that profits always tend to become as large as they can attainably be under any given set of circumstances. The most impressive parts of the theory of the firm and of distribution theory as explained by marginal analysis make liberal use of this postulate for purposes of defining and determining equilibrium (i.e., stable) positions. Increasingly of late, doubts have been raised concerning the empirical realism of this assumption, and whatever empirical investigations have been made tend, in the aggregate, to support these doubts, although no satisfactory single alternative has thus far emerged. It is not within the scope of this paper to consider the rather considerable literature on this matter beyond some little further reference to it in the closing section. What is more pertinent to our inquiry here is, as was indicated earlier, to examine the role which profits as a residual share play on a more technical level in our usual analysis. For this purpose it will be useful to begin by recalling some familiar concepts and relationships.

"Most of us can, no doubt, recall the satisfaction of being able to compute the equilibrium position of a firm… But it is possible that this exactitude has been purchased at a considerable price in realism."

Marginal economic analysis, which explicitly or implicitly underlies much of what is best in contemporary economic thought, places great emphasis on the existence or possibility of equilibrium on a number of different levels: individuals, productive factors, firms, industries, and the entire economy. It will suffice, for our purpose, to fix our attention on only two of these, factor and firm equilibria, since these relate most closely and immediately to the question of profits. More specifically, these are found to relate, respectively to equilibrium within factors (factor pricing) and to equilibrium among factors (equilibrium of the firm).

It is easy to form the impression that there exists, in each factor separately considered, an internal tendency to equilibrium which is the result of a balancing of the utility of income against the disutility of costs or scarcity. The principle of diminishing returns, when applied to each of the two arms of this balance, translates easily into diminishing marginal utility on the one hand, and, on the other, to increasing marginal cost or disutility. Moreover, by a theoretically simple — though by no means empirically simple — further step of expressing both of these relationships, as explicit functions of one independent variable, say output, the essential requirements for an equilibrium are satisfied — and very plausibly so. For stated in this way (i.e., in terms of the same variable — output in our case), the marginal utility of income to the factor is a decreasing function of output, while the marginal disutility of its costs is an increasing function of the same output, which in turn implies the existence of some calculable output at which they are equal. This output would constitute a point of equilibrium inasmuch as at all other outputs either marginal utility would exceed marginal disutility or it would fall short of it and therefore make an increase in total utility attainable by moving in the direction of the output which equalizes the two.

All of this will doubtless be familiar to the reader as a set of relationships which are frequently described in every exposition of economic theory, whether in words, or in algebraic notation, or by geometrical representation and would certainly not require restatement here were it not for the purpose of making one or two observations relevant to our discussion. Firstly, by substituting for the term "output" in our previous demonstration the equivalent term "supply," we can readily understand that the supply of a factor, in the sense of the amount of it offered, is represented as determined, in any given set of circumstances, by an equilibrating or balancing process. Secondly, it should be clear from what was said earlier that this balancing process finds its equilibrium point where total net utility, not total net money income, is at a maximum. The relevance of this to our discussion of profits can now be simply stated: it is that, curiously enough, contemporary theory applies this analysis to all the factor incomes except profits.

The fact appears to be that the adoption of the assumption of profit maximization is equivalent to denying that either of the above observations applies to profits. There is, on the one hand, no effort to incorporate into our explanations of profit any notion of an internal equilibrium of the kind we have described. The enterpriser is assumed to aim constantly and with unflagging force at maximizing something which is, in his case, miraculously also exempted from exhibiting the otherwise all-pervasive influence of diminishing returns. For one can be assumed to maximize profits (i.e., net money income) only on two further assumptions:

  1. that successive increments to net income are never valued less than preceding ones; and
  2. that nonmonetary costs (disutilities) either do not exist or, if they do, that they do not increase relatively to increments to net income.

It hardly needs to be pointed out that these latter assumptions are not only not applied in the case of any of the other factors but are diametrically opposite to the assumptions which are made in those cases.

In this sense it is possible to say that there is a very disturbing inconsistency in marginal analysis in applying one mode of approach to the profit factor and a radically different one to the others. The question naturally arises as to why this should be so. It is tempting to attribute this lack of conceptual and methodological uniformity to the often-cited fact that the enterprise factor does not exhibit as clearly as do the other factors structured elements of demand and supply. Two considerations, however, render this explanation unconvincing. At least on the side of supply, which is the more pertinent to our problem, all of the other factors contain, in one degree or another, elements of intangibility and indeterminacy, yet this has not prevented the application to them, with suitable minor qualifications or modifications, of the basic analytical approach outlined above. Moreover, the absence of explicit market phenomena in the case of enterprise, while it could be made to justify a somewhat different approach to profits, can hardly be expected to support the adoption of contrary assumptions of the sort we have mentioned. A much more plausible explanation of this ambivalence is to be found, I believe, in the technical requirements for the equilibrium of the firm, to which we now turn.

The equilibrium of the firm, which we have seen to be equivalent to an equilibrium among the productive factors, is determined, in marginal analysis, by a process of matching increments which runs parallel with the process we have already described and is, if anything, even more straightforward and familiar. We have seen how the equilibration internal to each of the factors (except for enterprise) results in a series of simultaneously potential equilibria which, taken together, comprise the supply schedule for that factor. The firm, as a decision-making agency (the role usually assigned to the profit-earning factor), is deemed able (theoretically, at least), and anxious, to make any change in the "factor mix" which offers an incremental advantage in terms of total net income. This process is assumed to continue until a point is reached at which no further change will increase total net revenue (total profit); beyond which, that is, any further substitution of factors will either leave this total unchanged or diminish it. This point is identified as the equilibrium of the firm's demand for productive factors, and any change in the relative prices of factors will cause the firm to readjust its demand so as to reach the maximum net income attainable under the new set of prices.

It is possible to state this equilibrium state in a variety of attractively determinate ways. At this point it is true that:

  1. the ratio of the marginal-physical-product of each factor to its price is identical for all the factors;
  2. the marginal-revenue-product of each factor is exactly equal to the price of that factor; and
  3. the marginal revenue for the firm as a whole is equal to its marginal cost.

Most of us can, no doubt, recall the satisfaction of being able to compute the equilibrium position of a firm from a schedule of costs and prices, as well as the sense of corroboration which issues from being able to translate these relationships into graphs and into differential calculus. But it is possible that this exactitude has been purchased at a considerable price in realism.

In the first place, it is important to realize that all of the alternative formulations of firm equilibrium mentioned above, as well as others not mentioned, are really nothing more than the spelled-out logical implications of one and the same proposition; that net revenue (or profit) is maximized — and this is really only an assumption, not a demonstrated fact. Secondly, the residual nature of profit is clearly implied; for example, a and b above are not strictly true as stated, for they do not apply to the enterprise factor itself. The return to this factor absorbs any incremental residue produced by improvements in the mix of other factors — and does so with ever undiminished appetite. Lastly, and most important, if the postulate of profit maximization is relaxed even a little, the equilibrium becomes greatly indeterminate, and all the attractive precision of the analysis is gone.

"It is easy to understand why economists would be very reluctant to give up an important part of an analytical apparatus which has been both impressive and serviceable for so long. But … this impressiveness and serviceability may have been purchased at a price in terms of consistency and realism."

The role of the postulate of profit maximization in marginal analysis is therefore both crucial to the determinacy of that analysis and yet not fully commensurable with its other components. The analytical function of the enterpriser is to keep pressing upon the differentials among the other factors until these differentials disappear; or, equivalently, to assure that the existence and the location of economic equilibrium is ascertainable by the methods of maxima and minima in the calculus. If he is to fulfill this function, the enterpriser must be assumed to act to maximize his profit under any set of given circumstances.

The trouble is that this function which business enterprise fills in our analytical models of the economy — however valuable it may be to these models — is seriously at variance with the function it serves, or can reasonably be expected to serve, in the economy itself. We are therefore torn between the Scylla of having to give up or recast much of what is most elegant and precise in our analysis and the Charybdis of insisting on a functional image of the enterprise agency which is out of joint both with other parts of our analysis and with accumulating empirical evidence. For if we were to suppose that, instead of maximizing net income, the enterpriser maximizes total utility (i.e., equates the marginal utility of net income with the marginal disutility of what he does or sacrifices to get it), the analysis of the profit factor would be put into full conformity with that of the other factors, but all semblance of a precise and calculable equilibrium would disappear. It would no longer be possible for the analyst to infer that, for example, a substitution of factors which adds to total net income would necessarily be undertaken, or even be desirable.

As a consequence, the old familiar benchmarks for equilibrium would cease to be reliable. Under these conditions it would no longer be permissible to assert that a firm tends to produce that output at which its marginal revenue is equal to its marginal cost; or that it will continue to make substitutions among the productive factors so long as the ratios of their respective marginal products to their prices are unequal. Moreover, it is by no means clear that the establishment of new benchmarks would be at all easy — or even possible.

It is easy to understand why economists would be very reluctant to give up an important part of an analytical apparatus which has been both impressive and serviceable for so long. But it is possible to suggest, if the considerations we have discussed have any validity, that this impressiveness and serviceability may have been purchased at a price in terms of consistency and realism — a price which was not always explicit and one whose practical burden, in a "mixed" economy, may be increasing.

III. The Real World of Economic Attitudes and Policies

The technical and abstract issues we have discussed appear to have, as was just pointed out, significant implications of a more practical sort for economic policy and general understanding. We shall conclude by considering a few of these.

"The rationality, the effectiveness, and the justice of public policy which taxes enterprise according to one assumption while it gears, say, profit-incentive policies to its opposite is at least dubious."

Aside from any analytical problems it may be fostering, the assumption of profit maximization is casting the enterpriser in the role of a sort of residual "economic man." The motivation of every other economic agent has long since been broadened, and made more realistic, by the admission of social, psychological, and other noneconomic elements. But while similar elements applicable to the enterpriser have been recognized and often mentioned, they have not been allowed to enter into our economic calculations, precisely for the reasons we have been exploring. It has necessarily followed that, even in our more sophisticated economic reasoning, the contrast between business enterprise and the other factors has increased in measure as noneconomic considerations have been incorporated for the latter but not for the former. To be an economic man among economic men is one thing; to remain an economic man while the others become more balanced is almost certain to make one appear relatively monstrous. It is at least conceivable that this contrast, however unintentional, acts to maintain and even nurture misconceptions and prejudices among the many, which, especially in a democratic society, eventually seriously affect public policy and collective negotiation.

Furthermore, although there is no a priori reason to suppose that the business man does not experience the diminishing return of added income in the same way as others do, the postulate of profit maximization necessarily implies that he does not. At the same time the pattern of profit taxation implies the opposite. The rationality, the effectiveness, and the justice of public policy which taxes enterprise according to one assumption while it gears, say, profit-incentive policies to its opposite is at least dubious.

Moreover, the role of a self-maximizing residual which we have contrived to assign to profits by the application of special assumptions is tantamount, almost literally, to that of an economic deus ex machina. And this is, in turn, just the sort of role that invites intervention or control; for is it not, after all, characteristic of fiscal and monetary policy, public regulation, and the like to operate necessarily in this way? If the part played by profits in the economy is found to be misrepresented, as we have suggested, for purposes of analytical tidiness, the need for correction is all the more urgent in an age of increasing recourse to government action.

The simple dictates of fairness and the interests of a free economy both point to the need for "humanizing" business enterprise. Inasmuch as realism in our economics points to the same need, it would be unwise to cling to any theory — no matter what its other attributes — which sacrifices this need for reasons of arbitrary neatness; more, it would be scientifically indefensible. Empirical observation casts considerable doubt on the thesis that enterprise always, or even typically, maximizes profits. Maximization, not merely of profit, but in general is not the only, or even the most plausible, mode of human search.[8] In sum, the evidence from a number of other sources and disciplines converges with the foregoing analysis in calling for the abandonment of the profit-maximization postulate.

One final word. One is naturally led to wonder how economic theory would fare if it had to do without the assumption of profit maximization. Any such concern is, of course, irrelevant; but it is also largely misplaced. The affirmation that a hypothesis like profit maximization is untenable leaves the economist no alternative but the ancient scientific one of backing up and trying again. And in this connection, two observations seem worth making. The first is that the present hypothesis cannot, ultimately, be replaced except by a better one, so that it is not so much a question of creating a void, but rather of setting about systematically to search for improvement. And the very fact of searching would offer the considerable immediate advantage that economists would probably have to be more tentative and prudent in translating the present theory of profit into policy recommendations.

The other point is that economics will, in the course of self-examination find itself forced to do what it, and social science generally, has thus far been content to avoid: to seek to devise their own quantitative methods instead of merely trying to accommodate to those of other disciplines. In the words of some who have themselves attempted some path breaking of this sort:

"The importance of the social phenomena, the wealth and multiplicity of their structure, are at least equal to those in physics. It is therefore to be expected — or feared — that mathematical discoveries of a stature comparable to that of calculus will be needed in order to produce decisive success in this field…. A fortiori, it is unlikely that a mere repetition of the tricks which served us so well in physics will do for the social phenomena too."[9]

It would, I believe, be difficult to find a task with more intellectual challenge or potential practical importance to commend to the imagination of a new generation of economists.

Suggested Readings
  • Edwards, E.O. and Bell, P., eds., The Theory and Measurement of Business Income, Berkeley, University of California Press, 1961, ch. 1, 2.
  • Kirzner, I.M., Market Theory and the Price System, Princeton, D. Van Nostrand, 1963, ch. 10, 11.
  • Knight, F.H., "Profit," Encyclopaedia of the Social Sciences, vol. XII, 1934, pp. 480–486.
  • Mises, L., Human Action, New Haven, Yale University Press, 1949, ch. 15.
  • Robinson, C., Understanding Profits, Princeton, D. Van Nostrand, 1961.
  • Rothbard, M.N., Man, Economy and State, Princeton, D. Van Nostrand, 1962, ch. 8, 9.
Notes

[1] For a patient and well-documented account, see C. Robinson, Understanding Profits, Princeton, D. Van Nostrand, 1961.

[2] Cf., e.g., American Institute of Accountants, Report of Study Group on Business Income: Changing Concepts of Business Income. New York, Macmillan 1952; and, especially, E.O. Edwards and P.W. Bell, eds., The Theory and Measurement of Business Income, Berkeley, Univ. of Calif. Press, 1961.

[3] Cf. J.A. Schumpeter, The Theory of Economic Development. (English translation of the 1911 German edition) Cambridge, Harvard University Press, 1934.

[4] Cf. F.H. Knight, Risk, Uncertainty, and Profit. Boston, Houghton, Mifflin, 1921; also his "Profit," Encyclopedia of the Social Sciences, vol. xii, 1934.

[5] This view, in its variant forms, stems from attempts to work out the implications of different degrees of competition: E.H. Chamberlin, The Theory of Monopolistic Competition. Cambridge, Harvard University Press, 1933, and J. Robinson, The Economics of Imperfect Competition. London, Macmillan, 1934.

[6] See P.A. Samuelson, Economics: An Introductory Analysis. New York, McGraw-Hill, 4th ed., 1958, p. 598.

[7] Ibid., ch. 30.

[8] One possibility, for example, is that the objective may be a minimum level or threshold of satisfaction, cf. H.A. Simon, Models of Man (New York, 1957). Simon's concept of "satisficing" has psychological plausibility and is in accord with some types of observed enterprise behavior.

[9] J. von Neumann and 0. Morgenstern, Theory of Games and Economic Behavior, 2nd ed., Princeton, 1947, p. 6.