Profiteering

by Don Boudreaux on August 11, 2014

in Growth, Inequality, Innovation

This post is prompted by my reading Ben Zycher’s excellent essay “In Defense of Price Gouging and Profiteering“.

Dick and Jane are neighbors; both are entrepreneurs.  Both Dick and Jane each pioneer the innovative introduction into the market of new products: Dick sells didjets and Jane sell jadjets.  There are no legal restrictions on other entrepreneurs entering the market to compete directly with either Dick or Jane, but the special and unique talents of these each of these entrepreneurs assures each that no other serious competitors will arise for at least a year.

Dick invested $2 million to cover the cost of producing didjets and making them available for sale to the public.  During his first year of operation, he produced 200,000 didjets at an average total cost of $10 per didjet.  The market price for didjets turned out to be $10.50 per didjet.  Dick sold during that year all of his 200,000 didjets.  Dick’s enterprise is profitable; he pockets during that year $100,000 of profits (for an annual rate of return on his investment of 5 percent).

Jane invested $2 million to cover the cost of producing jadjets and making them available for sale to the public.  During her first year of operation, she produced 2,000,000 jadjets at an average total cost of $1 per jadjet.  The market price for jadjets turned out to be $100 per jadjet.  Jane sold during that year all of her 2,000,000 jadjets.  Jane’s enterprise is very profitable; she pockets $198 million of profits (for an annual rate of return on her investment of 9,900 percent).

(For purposes of this exposition, let’s ignore taxes.)

Further suppose that Dick donates $80,000 of his $100,000 profit to a school for special-needs children.  Dick is frugal; he lives only off of the remaining $20,000.

Jane is neither as frugal nor as philanthropic as is Dick.  She spends $97,000,000 of her profits on original 19th-century paintings for her private residence.  She spends $1,000,000 on her other living expenses.  She invests the remaining $100 million in a larger and better jadjet factory.  She gives not one cent to any philanthropic cause.

Some questions:

1. Is Jane a “profiteer”?  After all, she could have still profited handsomely had she chosen to sell her jadjets at a price of, say, $10 each rather than at $100 each.

2. Which (if any) of these two entrepreneurs contributes most to human betterment?

It’s important to realize that by far the greatest benefit that successful business people contribute to society is not whatever benefits flow through their charitable giving.  Those benefits are often real; they are also often detriments rather than benefits.  But it’s in entrepreneurs’ and businesses’ creation of – and in their efforts to make affordable – valuable goods and services for consumers that successful entrepreneurs, business people, and investors contribute most to society.

It’s important also to realize that profits can be higher than ‘normal’ not only as a result of socially harmful institutions (almost always government-granted special privileges to producers), but also as a result of conditions or facts that benefit society.  An entrepreneur who increases his or her profits by lowering production costs benefits society; an entrepreneur who creates a product that people are willing to pay very high prices for benefits society.

This last claim might sound counterintuitive.  But ponder the Dick and Jane hypothetical above.   Suppose that the product created by Jane would have had a market price, not of $100 each, but of only, say, $30 each.  Jane’s profits would have been lower.  But note that the lower market price ($30) of Jane’s jadjets would have meant that, at the margin, each jadjet contributes less to human well-being than it would have had the market price been $100 each.  The market price of a good or service reflects the value that one additional unit of that good or service contributes to human welfare.  As long as no one is prevented by government from entering into competition with Jane, then the higher is the jadjet price that Jane fetches from consumers voluntarily spending their own money, then the greater are Jane’s contributions to society through her entrepreneurial creation of jadjets.

Put differently, a ‘high’ price of some good or service can be the result either of low supply or high demand.  The former is unfortunate – and especially so if that low supply is artificial, created by government barriers to the expansion of the supply of the good or service.  The latter, in contrast, is unambiguously good.  The more successful an entrepreneur or business is at creating and offering for sale a good or service that consumers like, the higher is the price that consumers are willing to pay for that good or service.

….

Now here’s a third question: If Dick and Jane were both, prior to their successful innovations, ordinary, middle-income denizens of society, then Jane’s innovation led to greater income and wealth inequality – so, ought we lament this result, or at least regard it as being a ‘cost’ of Jane’s unusually great success at innovation?

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