Marxists, beware. In Chapter 8 of Foundations of Economics, Shawn Ritenour explains how the economic phenomena of interest and profit, both of which are anathema to the socialist Left, are natural and necessary features of life in a division-of-labor economy.
Having established the principle of time preference in earlier chapters, Ritenour simply and efficiently shows in the first few pages that interest is a normal expression of that universal phenomenon. People value present money to future money, and ceteris paribus they will not willingly give up the former for a term unless they are promised a greater amount of the latter at the term’s end. The precise amount of future money demanded in exchange for present money will vary depending on whether people have a relatively high time preference (more future money required) or low time preference (less future money required).
Ritenour shows how investment in all areas of the economy tends to drive returns in any industry towards the overall interest rate, which in turn is an economy-wide expression of time preference. Industries experiencing greater returns attract more investment, bidding up costs for factors of production and lowering returns. Conversely, industries experiencing lower returns attract less investment, lowering demand and reducing costs for factors of production, thus raising returns.
Ritenour shows how the overall interest rate is determined by the cumulative demand for present money by both consumers (for vacations, homes, cars, etc.) and the owners of the factors of production (who demand present money from entrepreneurs for the use of their factors) along with the available supply of present money from savers. These factors combine to form a price that functions in the market like any other. The interest rate changes as people’s time preferences changes, altering both the supply and demand of present money.
Ritenour’s discussion of profit will surprise readers who have always assumed that the concept is identical with “net income” from business operations (fortunately, I was not among this number, having read Böhm-Bawerk years ago). Much of what is often viewed as profit is in fact interest accruing to the entrepreneur (if he uses his own capital to finance his business activities). Only the portion of his overall return net of the interest and wages he owed himself can be considered entrepreneurial profit.
This distinction is important because it helps us isolate the ability of the entrepreneur to forecast demand for the goods or services he produces. It’s possible for an entrepreneur to receive a positive return on his investment and still make a entrepreneurial loss. Ritenour uses the example of someone who builds an office building and sells it for a positive return, but one less than the market rate interest. In this case the builder has made an entrepreneurial error and has actually suffered a loss in that area.
Ritenour closes the chapter with sections on the socially beneficial nature of entrepreneurship. Successful entrepreneurs are ones who provide people with what they want. Their profits provide them with more to invest and continue providing people with what they want. Unsuccessful entrepreneurs fail to anticipate society’s wants and are punished with losses. The tendency is for society’s wants to be satisfied more fully through the direction of resources to the successful entrepreneurs in the form of profits. Ritenour points out that for this to work, we must have market prices to convey to entrepreneurs accurate information about people’s desires.
I’m planning to complete my series of blog posts on this book by June 5. Eleven chapters remain, so expect to see many more posts of this kind in the next few weeks.