THE CENTRAL IMPORTANCE OF NORMAL PROFIT
IN POLICY ANALYSIS


The last time I checked, General Motors was the world's largest corporation. It's exact
position doen't matter from the standpoint of this analysis -- only its relative bigness and
recognition by the public as such. For, being big and well-known, GM also has some
baggage it must bear among many minds in the populace. It is almost as if there is a
cheering section out there when GM loses money, and when the make money, these same
elements are quick to decry exorbitant profits. This is because it is not uncommon -- or
irregular -- for GM to make what most would consider 'really big' profits. The difficulty is
that even if GM were to earn $ 8 billion profit that is not really big bucks! This is true
because of the capitalization of the firm. It shows up in the stocks and dividends, which
the Board has made sure to pay even when the company was in the red. They do this, of
course, if part because they are stockholders, too, and want the dividend, but also to
maintain the value of the stock, and thus the corporation. But that, too, seems 'greedy' to
some. How can a business pay dividends when it lost money?

These are basic, and critical, questions which policy analysis too often seems to overlook
in its haste for publication or approbation. It also identifies policy analysis with the left
which is too dominant in policy and academic circles, and shows its color whenever such
shallow pronoucements are made by them. 

The problem here begins with the word profit, which to many people is a dirty word. It
almost seems that if someone makes money, there are those who would like to think that it
must be ill-gotten. Now, this is not to argue the validity of the assessment that such is a
too common sentiment in America. If anyone thinks that way, it is too many people, and
the consequences are dire.

To the accountant perhaps, as in  most minds, if GM makes a $1 profit in a fiscal years,
then they are in the black. They have made money! But in reality, they have lost money.
That is why economists talk in terms of economic profit and economic loss. To understand
this, we need to think about the prospective purchase of a share of GM stock. A party has
several thousand dollars to invest in the market, and is contemplating this acquisition. The
decision will hinge on many factors, not the least of which involves the relative return
compared to its current one that this money will receive. If it is simply in a savings deposit
account earning 4 % interest per year, there must be some concrete sense that the return
of the stock purchase will exceed that by some measure, because of the added risk of the
altered investment account. Of course, there may also be the promise of greater -
substantially greater -- return, but such profits are not common, and are not the basis of
sound investment decisions in most cases.

GM is so big in its capitalization and the value of its stock high enough that an $8 billion
profit may not be a greater rate of return than the 4 % the bank is paying on savings. Nor
may the dividend the Board votes even when the business loses money be a greater return
than 4 % -- or at least not greater enough to warrant the transfer and investment. Of
course, there are other factors such as prospective speculatory return on stock or the use
of stock as collateral. 

A similar analogy would be a scenario in which I have $400000 in a savings account (or
any investment) and am considering reinvesting it to start a business. If there is little
prospect for a greater return than the 4 % currently being drawn, what is the motivation
for investment? There is none. This is all pretty basic, even though it does elude a lot of
folks. And without investment, the economy does a nosedive and jobs and income are lost.

Such concerns are, of course, the essence of investment decisions in a market economy,
and are the basis of high living standards in these economies. That is why a more precise
definition of categories of profit is necessary. A $ 1 profit for any firm, let alone GM, is
not a profit at all. It is an economic loss. At the same time, an $ 8 billion profit for GM
(or the dividend and rate of return on a share of GM stock) may not be anything like
exorbitant profit. It is probably what economics call a 'normal profit.' With GM stock
currently going at approximately $  60 per share, it would be necessary for it to pull a
return of about $ 3 per year dividend to warrant a transfer of savings earning 4 % to its
purchase, without considering other factors of cost and benefits which may offset each
other.

An excess above $ 8 billion may be an economic profit, but even that can be justified on
the grounds of compensating for past losses or risk, it being the basis of further
capitalization/capital investment, or enhancing the investment attractiveness of the
business. Thus, competent analysis must not overlook these more sophisticated terms
regarding benefit and loss::

Economic Profit -- a return in excess of normal profit

Normal Profit -- a return at least equal to the cost of the investment in terms of alternative
lost prospective return (this also must include often the foregone salary the entrepreneur
would have earned).

Economic Loss -- less than a normal profit but the firm still operates in the black.

Accounting Loss -- costs exceed revenues; the firm is operating in the 'red.'

But the point here is that a firm may be effectively operating in the 'red' well before it
shows up as actually 'lossing' money. Any business not making a normal profit is operating
in the red! And the consequences of such a situation have serious implications for the
investor, the firm, and the economy -- as they must for policy analysts. For without
recognition and active consideration of this point, the delatory consequences of policy are
potentially catastraphic. A business will not have to face being driven into the red for the
policy to have dire consequences for all parties involved, including the government and the
populace. Indeed, any policy which infringes on normal profitability is going to hurt the
country, the people, and the government, and not merely the business or investors
involved. And, given the tendency of decreasing returns to scale
(please note the use of the word 'tendency,' not 'law' -- there is very little in economics
which can be described as a law), this is all the more imperative as a prime consideration. 

It is certainly not always possible for a firm to 'raise its prices' to cover the additional
burden of a policy, either (the fallacy of tax incidence has been explored elsewhere in this
issue).  The market may simply not bear it. Particularly in more competitive markets, such
as the monopolistic competitive setting which is the most widespread market in the US,
there is little prospect for anything beyond a normal profit.  That is basic microeconomic
fact. Nor can it be overlooked that it is not the 'wealthy' which benefit from capital gains
(or are harmed by capital gains taxes), since most of us are invested in great amounts in
such concerns even if vicariously through insurance, savings, pension funds, or
consciously through mutual funds in such concerns. It is another question whether any
economic profits, whatsoever, are to be taken as bad, or as to when they are to be, since
profit is the substance of social surplus which is the fuel of investment, growth, and
development. The apparent popularity of redistributive schemes in the US is mind -
boggling on this basis. But the concern here if for merely normal profit.

The rhetoric of the 'price-gouging' giant firm making 'exorbitant' profit at the cost of the
public, or the firm avoiding bearing its 'fair' share of the tax burden, is a scam or
misunderstanding of economic realities. Its practice is often sheer demogoguery by
politicians of usually a certain perspective, but it nevertheless has very troubling
consequences for nearly everyone. The consequences of this type of perspective would
have been to have decaptitated the production of the level of living standard we currently
have. For the future, for the rest of the world, the impact of such ill-informed policy could
only be to drive us towards lower living standards. But more than that, given the huge
burden of the cost of governance and its commensurate drain on resources and the
diminutive impact of that on the private sector -- and its drain on prospects of normal
profit, the very existence at such a level of the bureaucratic leviathan is a drag on
economic growth and development, and ultimately on wealth generation. The arc of
collectivism is toward Malthus.



Return to beginning of ejps