13 Thoughts on Profit

1. Take the fundamental example of exchange. I have 10 cows, and you have 100 chickens. I have plenty of milk, but really want some eggs; you’re tired of having to eat eggs with no milk. I trade you one of my cows for ten of your chickens.

Who profits? We both do, because we voluntarily made an exchange and now we’re both better off.

2. Why should we treat (1) any differently simply because instead of ten chickens you give me fifty dollars?

3. I don’t know the answer to (2), but many of us implicitly make this leap. We’re fine with (1), but condemn the profits of large corporations. In part, this is because we are examining only one side of the transaction — we ignore our own profit.

4. Maybe you want to say the difference is that corporations are exploiting workers or the poor or the natural environment. Let’s put this issue to the side for now, that’s a post for another day. I will say briefly, though, that while these arguments are not completely without merit, they are often exaggerated or misunderstood.

5. Maybe you want to say that the exchange isn’t really voluntary at all. See the work of Mike Munger on the concept of euvoluntary exchange. Elsewhere, he has tried to extend the work of John Locke and the latter’s argument regarding the morality of certain types of transactions. Or see the blog Euvoluntary Exchange (for example, here). Again, put the specifics to the side for now.

6. Maybe you want to say it’s a matter of degree. Corporations profit much more than the individuals they are transacting with. This is the issue I want to focus on.

7. The textbook answer to (6) is that the consumer and producer surplus are determined by the elasticities of the demand and supply curves for a particular product. In English you can think of it in the following way. Through some magical process a “market price” of iPads emerges. This price is sort of like an average of what consumers as a whole are willing to pay and the price at which Apple is willing to sell. Let’s say an iPad costs $500. Note, however, that there are a small number of consumers who would have paid $1,000 for one. A few more would have paid $900, even more would buy at $800, and so on. At, say, $515 most of the people who bought an iPad at $500 still would have purchased one. You can see that all of these consumers have a “surplus.” That is to say, there is a gap between what they would have been willing to pay and the price at which they can purchase an iPad. The consumer is saving money so to speak, or, in other words, making a “profit” since they are purchasing an iPad at a cost less than that at which they value it. This is akin to Apple selling an iPad for some amount above the cost of producing it. Both consumer and producer are profiting.

In the case of the producer, though, the surplus — the difference between what Apple would have sold the iPad for and the market price — is slightly different than “profit” as the term is normally used; but you can see that the two are conceptually related. We would have to know something about the cost curve of iPad production to define the relationship exactly.

8. So knowing the shape of the demand and supply curves (and the cost curve of the producer) you could state definitively which group “profits” more. But in reality we don’t know what the shape of these curves actually looks like. We could survey consumers and ask, “Well, how much would you have paid for an iPad,” and get some sense of the demand curve for iPads. In practice, however, people aren’t so good at questions like this. They don’t really know the answer absent the context of the actual decision to purchase (or not). We would end up with a demand curve plus or minus some non-trivial error. The supply curve of producers would be more precise, but not without error itself.

9. Actually, the situation is worse than that. In practice the demand curve doesn’t exist at all, at least in a way that would allow us to determine the true consumer surplus. It’s not simply that consumers aren’t good at answering the hypothetical question regarding how much they would have paid for an iPad, but rather that this dollar amount changes over time. In six months maybe they realize the iPad is the best purchase they’ve ever made. It has allowed them to ditch their work laptop or to mobilize their electronic life in a way they never imagined. Knowing what they know now they would have paid $700 for it. Conversely, perhaps they think the iPad is just an oversized iPhone useful only for playing Angry Birds. “No more than $100, if that,” they’d say when asked.

10. Even more confounding for measuring profit is that the value of potential and already transacted purchases changes from day to day. On a sunny day I’m in a good mood, on a cloudy day I’m a little sour. This will affect the way I value various goods. In fact, anything that affects my mood will temporarily change the way I value goods. If my mother dies I can’t even conceptualize what value means for months as I focus on emotional recovery. The day after my bonus check arrives in the mail I’m probably willing to make purchases I’m not willing to make in six months after I realize the money must last the entire year. When my computer catches a virus and loses the presentation I’ve been working on for weeks I probably value it a lot less than when I lay in bed with my children and watch Finding Nemo on Netflix.

11. Again, for producers the situation isn’t quite as drastic, but the supply curve is probably more variable than we think. After all, there is some person, or group of persons, that determine what a particular item will sell for, when, and where. Though we (or at least they) would like to think the decision is emotionless and determined solely by well-analyzed consumer data, humans are humans and therefore both fallible and inconsistent.

Perhaps saying that the curves “don’t exist” isn’t quite right. I suppose it is more accurate to say that they are constantly changing and unknowable at any given time. But of the two, the demand curve is far more volatile and fleeting.

12. This is not to say that supply and demand curves are not useful. Quite the opposite, in fact. So too is the concept of rational economic behavior. The question is one of degree. Microeconomics is very good at telling us the direction of outcomes given certain inputs, but not as good at determining the magnitudes.

13. In short, to determine how much consumers profit from a transaction we have to know something about how much they value the goods being transacted, but this can’t really be determined in any meaningful way. And so the question as to whether corporations or consumers profit more for any given transaction (or group of transactions) is moot (again setting aside possible exploitation and whether the transaction is indeed voluntary).

14. Bonus thought: A graphical representation of consumer and producer surplus from wikipedia. I would argue for two additions: error margins around the curves and a third dimension to represent the inter-temporal movement of value. Perhaps neuroeconomics, behavioral economics, and microeconomic theory will one day join forces (along with sufficiently advanced technology) to produce such a graph. For now, though, we’re stuck playing Angry Birds.

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One thought on “13 Thoughts on Profit

  1. I know I’ve posted before about the euvoluntary legitimacy of trade with large firms. I think this is the post I’m thinking of, but I could be wrong:

    http://euvoluntaryexchange.blogspot.com/2012/05/roses-are-red.html

    Anyway, I tend to agree with your conclusions. Demand schedules behave oddly for individuals and are assuredly stochastic in the aggregate. Hm. Now that I think about it, I might have myself another little 2×2 matrix to analyze: firm size vs. market thickness. I think you’re on to something. Thanks for the idea!

    And if you’re interested in euvoluntary exchange, please feel free to stop by the blog any time.

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