Systems Matter Part 11: Profits and Losses

Repeatedly we have asked why some countries are poor and other countries are rich. Our discussions keep bringing us to the conclusion that the countries that are wealthy, or becoming wealthy, are those that are capable of producing higher levels of income. Those higher levels of income are generated from successful production of goods and services based on the effective use of the country’s natural resources. 

In order to make the best and most productive use of the natural resources in a country, the individuals within that country must experience cultural and economic freedom. They must be free to pursue their own interests and be allowed to make choices that they personally determine will result in their ending up better off. When those freedoms exist, the individuals are allowed to generate higher incomes by creating new wealth to be enjoyed by themselves and their country. To the degree that those freedoms are denied or restricted, the country will be less wealthy. 

It is good to remember that profits are absolutely necessary to the existence of enterprises. Not very many people would run the risks of ever establishing a business without the possibility of making a profit. Without businesses, we wouldn’t have the goods and services we enjoy and to which we have become so accustomed. But let’s take a deeper look at the function of profit.

  • Profit: The phenomenon of profit is the indicator of growth. It is the mechanism that sends the message that growth is being experienced in the economic system. Profits inform us of the positive value that has been added to the country’s economy, sometimes referred to as the gross domestic product (GDP).
A technology company in the Silicon Valley of California might take a measure of sand and transform it from the recognizable sand granules into a highly desirable and useful computer chip. They may sell the computer chip to another manufacturing company or to an individual. The expense required to transform the sand into a marketable product would be considered their cost. The money received from the purchaser of the computer chip would be their sales price. The difference between the chip manufacturer’s costs and the sales price would be the company’sprofit. When the company registers its newly generated profit, it simultaneously records that the wealth of the nation has just increased by the same measure. That wealth represents brand new just- created riches that up until that time had neither existed nor been recorded.
Effectively built into the free enterprise economic model are inherent signals and guidelines that work for increased success and growth. No one specifically designed the model to offer such signals . . . it just functions that way. But those signals and responses all happen so quickly and so silently, even without any individuals or committees in control of the signals. As a result of the simple market forces, individuals are guided to use the nation’s natural resources in the best and most efficient way. That is all possible because the consumers, as well as the business folks, act with the same cultural and economic freedom of choice in the specific areas oftheir self-interest. They also believe that their choices will make them better off in the end.
When the consumers buy goods and services, their collective purchases direct resources to businesses that are meeting consumer wants. Their actions also direct resources away from businesses that are not meeting consumer wants. If the consumers purchase enough of a certain product to create a profit for the business, then the business can receive and rely on the signal that it should continue to offer that product for sale.

Adam Smith saw all of those seemingly instant and automatic signals coming out of the existence of the free enterprise economic model, and referred to the anomaly asthe invisible hand. That invisible hand utilized all the unintended consequences of all the individuals who were simply acting with cultural and economic freedom of choice while pursuing their own operations of self-interest. 

Even high profits send an important signal and serve a necessary function. High profits attract other players into the industry. As new businesses come in, the competition increases. It is the competition of the new firms that forces prices and profits down, thus increasing the efficiency of the total economy. It is interesting that profits encourage the very competition that keeps profits in check. 

The inherent signals coming from the components of prices, profits, losses, and wages, determine not only which industries continue to exist but also which products survive. Only profitable industries, firms, and products survive. That also makes for a more efficient economy. 

  • Losses: The concept of losses plays an equally important role in sending signals to the economic marketplace. Businesses must match their production choices with the consumer choices or face losses and eventual bankruptcy. In the system, profits seem to be the rewards and losses seem to be the pain. But in the long haul, even the pain of the losses serves to bring about rewards. Losses send the signal that something must change because the natural resources are not being used for the highest and most efficient means.
Just as high profits in a certain industry will send signals for new businesses to get involved in the same activity, so also do losses send a strong signal for others to pack up and get out. Those negative signals are strong and equally important. 

When a business incurs costs that exceed profits, it is in trouble. It is time for it to change its approach and use its resources some other way. That is a hard lesson to learn. But failure in a business simply means that the business is not making other people better off. When that failure occurs, the resources that the business was using can now be used for other purposes. Other managers can now have a go at managing those resources. It is hoped that they will be successful in making people better off, and, as a result, make a profit from redirecting those resources.

 It is important that we ask why some countries are wealthy and others are not. It is likewise important to ask why some countries were wealthy and are presently becoming less wealthy. It is important to investigate at what level the individuals of a country are presently experiencing cultural and economic freedom as they access a country’s natural resources. It is still important to observe if the individuals are allowed to generate higher incomes by creating new wealth to be enjoyed by themselves and their countries. 

Let’s keep observing and asking questions. Let’s keep discovering! 

Next Week: Wages

(Research ideas from Dr. Jackson’s new writing project on Cultural Economics)

© Dr. James W. Jackson   

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