Friday, February 09, 2007

Understanding Economics: Profits

The existence of profits and losses plays a crucial role in any free market economy.

Profit is the difference between income and cost. In a free market, transactions take place only when both parties freely agree. Since people value different goods differently, both parties benefit from trade.

When people or businesses sell a product for more than the cost of production, they have used their resources wisely and improved their fortunes.

Some people promote envy and hatred against those who make profits. Others believe that success should be congratulated, not scorned.

Profits are not automatic for people or businesses because they cannot set prices wherever they want. A price is determined by the value of a good, which is determined by consumers' demand, and is unrelated to cost of production.

Demand can be difficult to predict. Consumers may not like a product, or be willing to pay what the producer hopes. Competitors may make a better product. Businesses have fixed costs like labor and facilities that must be paid even when sales are low.

Beyond benefiting the seller, though, profits serve an essential role in a free market economy. They reward productive economic activity. Profits can only be make by serving the needs of the customer. They provide information about what economic activities are beneficial to society.

Profits also provide incentives for businesses and entrepreneurs to benefit mankind. In a free market, the hope of financial gain causes them to seek ways to convince people to give them money. This means providing goods and services that people want.

Some people seek to restrict the profits that businesses can make. They call large profits "windfall profits," as if they are the result of luck rather than hard work and good planning, or "obscene profits," as if there is something wrong with prosperity. For what it's worth, most large businesses are owned by millions of shareholders through mutual funds, pensions, and insurance policies.

Restricting profits creates a disincentive to the benefits they create. Productive economic activity is reduced, and people are left without some good products and services.

The same economic logic applies to negative profits, or losses. While losses are not good by themselves, they serve an essential economic role. They provide information that something is wrong with what a business is doing. A business that loses money must change its actions or it will go out of business. Businesses that do not serve the customer well are weeded out of the economy.

Some people advocate limiting the losses of businesses. This is typically presented as "saving jobs." But this interferes with the necessary function of losses. If the possibility of failure is eliminated, businesses lose the incentive to improve and serve their customers. Corporate bailouts only serve to subsidize failure.

Profits and losses both serve to promote human prosperity.

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