Interest and Profit

foundationsofeconomicsMarxists, 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.

About Dr. J

I am Professor of Humanities at Faulkner University, where I chair the Department of Humanities and direct online M.A. and Ph.D. programs based on the Great Books of Western Civilization. I am also Associate Editor of the Journal of Faith and the Academy and a member of the faculty at Liberty Classroom.
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4 Responses to Interest and Profit

  1. Tony Gill says:

    I haven’t read Ritenour, but it seems as if he does convey the social importance of profits correctly. In a perfectly fluid economy with complete information and low transaction costs, profits should average out to be zero in the long run. This is because, as Ritenour correctly points out (per your interpretation) that positive profits send signals about how to allocate resources. New entrants will compete away any positive profits to the point of each entrepreneur’s opportunity cost. Ritenour also correctly points out that a true calculation of profit is not sale price net of production costs, but needs to take into account those entrepreneurial opportunity costs.

    The problem is that opportunity costs are difficult to calculate as they consist of a lot of intangibles. One might argue that my opportunity cost of going into the restaurant business would be the salary that I would give up teaching political economy. That is the easy part of an opportunity cost. However, we would have to factor in all the hassle with setting up a new business, my relative levels of enjoyment between the two professions, etc. (Most students don’t understand that only some costs can be calculated monetarily.) All these intangible factors lead to varying opportunity costs for different entrepreneurs, which in turn makes the market very interesting (and my leave open the opportunity for some entrepreneurs to capture rent). The easiest way to conceptualize this is to consider a set of potential restauranteurs in a town. Some people love to cook and would be happy to earn a return on their investment of 2% above their production costs. That 2% would represent the bottom floor salary they are willing to accept to stay in the business. However, other folks might not enjoy cooking as much and would need a return of 5% in order to enter the market. These folks might not like cooking, but they know how to satisfy customers demands. If the overall return on investments in the restaurant business in a town drops to an average of 4%, all the folks who wanted a 5% return will drop out (or not get in), allowing the chef who loves cooking to earn 4% above costs, which is better than the 2% he desires. In that regard, variegated interests and opportunity costs can allow for postive profits to exist.

    • Dr. J says:

      He also includes entrepreneurial wages in the costs that must be subtracted from the overall return before profit is figured. What if we just viewed the restaurateurs who love cooking as people who are willing to accept a lower entrepreneurial wage? That would make the profit margin greater and maybe match or exceed the 5% demanded by the restaurateurs who don’t like cooking, while still maintaining lower costs. Or is it more appropriate to calculate entrepreneurial wages at the market rate, whatever that is?

  2. Tony Gill says:

    This is where it all gets rather murky. The typical Econ 101 textbook assumes a set wage or salary, often based on the comparative market wage. But that neglects that we value things differently, including our own labor. That is why it is almost impossible to calculate what the “going rate” for an entrepreneurial wage is. Some people like to start businesses for the sheer joy of it and would be happy with a salary of $30,000, whereas others would balk at that salary and move into the private sector. Shoeless Joe Jackson would play baseball for “nuttin'” (see Field of Dreams), whereas a Daryl Strawberry would quit if he didn’t get $X million. Thus, an “entrepreneurial wage” is somewhere above the minimal opportunity cost for the entrepreneur, and that will vary by individual preferences. He (or she) may be able to earn a wage above that minimal opportunity cost, which is great. We call this “rent,” and rent is not bad so long as coercion is not used to obtain it (which is what we are usually referring to when we talk of rent-seeking in political economy).

    This is why the Austrian school is so powerful, particularly Hayek, when it comes to understanding how we communicate value in society. Hayek makes the assumption that we can’t really know the value of anything with exactitude (or even inexactitude, if that is a word). A free market serves to let different people exchange with one another to find their own particular value for different things (including entrepreneurial labor).

    One of the problems with the standard textbook treatment of this is that we make the assumption that we can calculate (or make reasonably accurate assumptions) about what the value of entrepreneurial labor is … and then set policy according to that belief, be it minimum wage laws or NSF grants or prizes for innovation. Take an NSF grant as an example. The NSF assumes that your “entrepreneurial wage” would be equivalent to your academic salary (or sometimes they have set pay rates depending on academic status). But what if I would be happy to do a project for half my salary so as to undercut any grant competitors. NSF policy does not allow me to do that, and thus we end up overpaying the grant recipient and possibly misallocating lots of resources.

    That is why when I teach this stuff I try to avoid formulas and charts and get to the underlying intuition of economics, which is what the Austrians and their progeny tend to do so well.

    Does any of this make sense? I have an intuitive sense of this, but it is hard to type up on a blog.

    • Dr. J says:

      Yes, it makes sense, and it reinforces what I see as the problem of getting too quantitative in the study of economics. The Austrian insistence on treating value only as ordinal and never cardinal takes on new importance when considered of the light of the issues you’ve raised.

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