22 August 2007

Profit v. Rent

If I were the king of viscera, the one visceral truth I would try to drive home is the difference between accounting profit and economic rent.

Accounting profit is simple. (Well, actually it's not at all simple. But for our purposes here today we're going to ignore the difference between cash flow and income, and depreciation and other things that make the following sentence wrong.) If you have a business, and the business has more money at the end of the year than at the beginning, then the difference is profit. To many people who don't understand the difference between profit and rent, profit seems suspicious. If you didn't have any profit, you could charge less and consumers would have more money. People would be better off. Rich trust fund babies would have to go out and earn their money, rather than just cashing checks eukered from the pocketbooks of honest working families. It's only selfishness that causes sellers to charge more than cost.

Economists look at it differently. Let's consider a business worth $1,000,000 on January 1 and $1,050,000 on December 31. The company accountant (and the IRS) tell the owner that he made a profit of $50,000. He feels pretty good.

[Completely tangential aside: People sometimes object at this point that the owner is paying himself a salary, and that's profit, too. Owners sometimes think this, too. They're kidding themselves. If the owner wasn't working for the company, the company would have to hire someone to do whatever the owner does. The owner would have to go out and get a job. Whatever the owner's market value is counts as a legitimate cost of business and not profit. It's true that, for tax reasons, some owners pay themselves above market rates. But, oddly, I've seen more business owners (particularly restaurant owners) who pay themselves below-market rates because, otherwise, the business would fail.]

An economist would point out that, had the owner taken his $1,000,000 and bought a one-year Treasury, he would have made about the same amount of money with much less risk. The economist then says that it isn't sensible to say that the owner "profited" if he took on more risk without getting more money. For the economist, a supplier of capital hasn't really profited unless he has made a greater risk-adjusted return than he would have gotten from the next best use of his money. Because the word "profit" is taken, and because economist love to confuse, this concept is called "economic rent."

One of the key implications of the concept of economic rent is that capital is an input like any other. It has to be paid for and, if scarce, the price has to be bid up. Riskier investments have to pay more than less risky investments. In this way, capital is attracted to the best (most lucrative) investments first. In other words, much of what is presented as "profit" in accounting reports is better understood economically as a cost that, like the cost of raw materials or machine tools, can't be avoided.

Where this distinction (or people's failure to make this distinction) has bite is when it comes to discussions of regulating or nationalizing some industry for the good of the people. One argument that is always made is that the evil private businessmen are, gasp, making profit and, after regulation or nationalization, the company won't make a profit (or, at least, a outsized profit) and that money can be returned to the people. This is exactly like saying that, for example, the pharmaceutical industry spends lots of money on new pill making machinery and, if we stopped them from spending that money, pills would cost less. In both cases, pills will soon cost nothing, but not in a good way.

Nor does taxation make any difference. If the government decided that it didn't want to pay for the steel it uses to make bombers and so it just stole the steel, the steel is still being paid for, albeit not be the end-user. Since any end-user will use more steel if it's free, the result is that a greater cost is being paid with less return than if the government just paid for it. That is a dead-weight loss. Exactly the same is true with taxation.

Finally, even if we can recognize economic rents when we see them, we still can't appropriate them without shooting ourselves in the foot. Outsized returns are a signal that supply is too limited. It attracts entrants into the market; investors can make more money there than elsewhere. The only exception is when there are barriers to entry that can't be overcome. The most common barrier? Government regulation.


erp said...

David, My husband is a CPA with over 50 years of varied experience and he thought your post interesting. His take is that while economics is theoretical and accounting is practical, profit by whatever name, is an integral part of doing business and even the so-called non-profits better make a profit or they'll cease to exist. One of his favorite sayings is, if you're losing money, you can't make it up in volume.

Government interference is the bane of doing business and the less of it there is, the better for us all.

Collectivists are totally clueless. They hate corporations above all else, yet corporations are merely people working collectively toward the goal of providing a product or service while maximizing profits for their investors. No profit, no investment, no company, no jobs, no technology, no cancer cures, no internet, no nothing.

Bret said...

"Let's consider a business worth $1,000,000 on January 1 and $1,050,000 on December 31. The company accountant (and the IRS) tell the owner that he made a profit of $50,000."

I don't think so (or at least usually not).

What a company is worth is the discounted value of the entire future stream of the company's earnings. The current profit is only one factor.

I'm not sure you've succeeded in driving home your number one visceral truth. But let's assume you have succeeded. Doesn't your last paragraph eliminate the need to understand the difference between accounting profit and economic rent?