From The Economic Way of Thinking, eleventh edition, by Paul Heyne and others, p. 195:
Profit arises from uncertainty. In the absence of uncertainty, any differences between expected revenue and expected total cost would be competed away and profits would become zero.
That sounds to me like too strong a generalization. Some remarks.
1. It shows the influence of Frank Knight. But would Knight have bought such a strong statement?
2. Economists, including the authors, point out that profits as reported by business include opportunity cost, particularly the opportunity cost of capital. Economic profit is less.
3. Elsewhere, the authors want to insist, reasonably enough, that taxes are paid by individuals, even when those taxes are called corporate income taxes. I would think that consistency would require insisting that profits accrue to individuals, even when they are called corporate profits. But if all profits accrue to individuals, then I do not see how we can separate economic rent from opportunity cost. Maybe Bill Gates made a lot of money from Microsoft because he happens to have a very high opportunity cost. OK, that sounds absurd, but still, he has a higher opportunity cost than someone with less drive and ability starting a software business.
4. Talking about the profits earned by shareholders is tricky. In the portfolio theory of modern finance, there should be no excess return from taking diversifiable risk. Unless I know something that everyone else doesn’t, I will earn on average a lower return by buying shares in a particular stock than by buying shares in the market portfolio. (I think this point tends to cut against point 3 above.)
5. How do patents fit into the story? Firms obtain patents in order to protect profits. Are patents simply government-chartered monopolies, leading to artificial rents? Or are patents a return on investment in research and development? In the latter case, perhaps one would say that if the outcome of research and development were certain, then profits from those activities would become zero.
6. It seems to me that there are other sources of market power that are defensible. I am not talking about defensible in a moral sense, but defensible in the sense that they will not be competed away. For example, there is reputation. If my insurance company has a reputation for being sound, then potential competitors will find it difficult to persuade my customers to switch. Another example is network effects. Wal-Mart has a lot of customers because it has cheap prices. Because it has a lot of customers, it is in a strong bargaining position with suppliers, so it can keep its prices cheap. But if a lot of companies try to create network effects, and some succeed and some fail, is this another case of profit emerging out of uncertainty?
Going back to the quoted paragraph, I think that it is either false or uninteresting. If we do not stretch our definition of uncertainty, then it is false. Alternatively, suppose that we make it true by arguing that profit from investment in intellectual property, reputation, network effects, and so on is only due to the uncertainty involved in such investment. A forced tautology of that sort is not interesting.
May I suggest applying/inserting the economic concept of Consumer Surplus into your thinking. Perhaps thinking in terms of how much Consumer Surplus is created and distributed by any given firm, and by what methods/strategies what portion of Consumer Surplus is monetized by that firm. I suspect that is what Paul Heyne (et. al.) may be referring to.
E.g., “Wal-Mart has a lot of customers because it has cheap prices.” The so-called “cheap prices” at Wal-Mart inherently represent greater delivered Consumer Surplus. That is the reason Wal-Mart has a lot of customers.
It always baffles me why economists focus exclusively on “profits”, “economic rents”, “excess returns”, etc. as the only explanatory factors, while blissfully ignoring the most important economic concept of all – Consumer Surplus.
Profits can be measured a lot easier than consumer surplus. It’s that old “looking for your keys under the streetlight” thing again.
You are quite right, Jeff R. Stated another way, it seems many “economists” proceed under the presumption that absence-of-evidence = evidence-of-absence. Baffling (and annoying).
What is even more baffling and annoying is that these same “economists” presume that the “profits”/”losses” they actually find “under the streetlight” are something relevantly more than mere accounting fictions. The fact that they are generally accepted fictions – per Generally Accepted Accounting Practices/Principles (GAAP) – renders them no less fictional. And how many government policies and economic theories have been conjured up based on these mere accounting fictions? Baffling, annoying and mind-boggling.
Consumer Surplus, on the other hand, is quite real. (Just ask anyone who has exchanged Federal Reserve Coupons for some Consumer Surplus lately.)
Perhaps the economics discipline would benefit by exerting some effort towards a methodology for measuring, or at least estimating, Consumer Surplus. Perhaps an effort towards developing a set of Generally Accepted Economic Practices/Principles (GAEP) – which at least applies standards for measuring/estimating Consumer Surplus – might help. At least it would be more informative than ignoring Consumer Surplus altogether. Accountancy already does that quite adequately.
Competition equals uncertainty. And there are plenty of examples of profit without tangible uncertainty. That’s what “crony capitalism” is.
I think the authors are using Knightian terminology to convey a more Kirznerian understanding of profits. They do not make this explicit, but knowing their identity, it’s probably a fair interpretation. Which makes you wonder why they are not using more openly the Kirznerian terminology. Probably they want to appeal to a broader spectrum of Principles professors and are afraid to openly signal their Austrian background.
Good point, I could not agree more.
I can actually comment directly on Market Power for Microsoft – I had a small hand it…
The errors of an argument that if there were no uncertainty there would be no profit are two fold.
1. People and organizations are not the same in their competence. A great deal of Microsoft’s market power came from the simple ability to build and support software, said ability arising by hiring people (at high cost) who could do this task. People are NOT all the same. So just as an expert surgeon gains market power from skills and abilities the minimum wage laborer does not have, organizations can gain market power from skills and abilities others do not have. Intellecutal property rights are only helpful if you can deliver something in the first place, and the world is full of entities who have/had brilliant ideas they could never deliver on.
2. There is a long history of organizations running from being commoditized as though running from a fire. And so if all uncertainty about production of something is removed, so that profit is reduced to zero, there will be a correction in which entrants leave that market. One expects enough participants to leave so that the ones left can make profits.
What is this the Schrodinger’s Cat of economics? There can never be an absence of uncertainty. There may be an absence in the state you choose to measure but it will remain in other areas. And like Schrodinger’s poor Cat, you can’t know what state the enterprise will be in until you open it up to see. Even then, a seemingly certain enterprise in a state with little profit can suddenly be lifted to a very profitable state by altering a few post-transition obvious details. See the boring coffee business transformed into expresso shops.
Even if the industry is very stable with low margins, it can still profit off the uncertainty that consumers prefer to retain. Say the produce business, not very sexy, but after an area reaches a certain population, along comes produce vendors/grocery stores to profit from the consumer’s uncertainty of when they’ll wish to eat a kumquat. The consumer pays a bit more as profit to the vendor to keep from having to plan their kumquat consumption beyond a trip to the local store. While the vendor averages the uncertainty of any one consumer over a large number of consumers to sell a whole box of kumquats before they spoil at a modest markup. Even if the store has a regular kumquat consumer who can be counted on to take up any slack, they still have the uncertainty that the consumer might get hit by a truck.
The purpose of reputation is to mitigate uncertainty.