Tuesday, September 27, 2011

Where Profits Come From


Why Profits Matter

It is no secret that profits are the essential motivation for many activities in a capitalist economy. A firm’s profits greatly influence its decisions about production levels, employment, and investment. Naturally, profits play a dominant role in microeconomics, the study of individual markets and the firms, industries, workers, and consumers that constitute them.

Just as profits are critical to the behavior of a single company, aggregate profits (the combined profits of all firms) have broad implications for the larger economy. Production, employment, and capital spending for the economy as a whole are strongly influenced by aggregate profitability. Therefore, understanding the determinants of aggregate profits leads to powerful insights into these activities and other economic phenomena, including inflation, unemployment, and business cycles.

Yet conventional macroeconomics, the study of the economy as a whole, rarely considers the role of total profits. When most business cycle analysts address the economy’s overall performance, they focus on gross domestic product (GDP) and largely ignore aggregate profits. This is like assessing a firm’s health by looking at its sales but not at its bottom line. In fact, any comprehensive analysis of business cycle dynamics must consider aggregate profits. For this reason, where profits come from and what determines their magnitude are critical questions.

The view of the economy that focuses on the profit creation process is the profits perspective. This powerful perspective provides a broad, financial view of the operation of the economy. It highlights developing influences for prosperity as well as threats to domestic and global economic and financial stability. It offers further understanding of virtually every important macroeconomic issue—deficit spending, business cycles, trade imbalances, etc. It exposes misconceptions about the relationship between saving and investment and between wages and profits. It is based on a direct flow-of-funds analysis, not on statistical approximations of reality. Therefore, it involves no exotic mathematics, no idealized assumptions about human intelligence and behavior, and no rigid or unrealistic assumptions about how firms, consumers, and investors operate.


Related book: Profits and the Future of American Society