Economics 101

How Prices Work to Keep Profits Fair

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If I make a profit off something I sell, how is it that the person I sell the item to is also better off? Shouldn’t one of us be worse off from the exchange so that one of us can benefit?

It turns out the price system is the way in which two people can benefit from a business transaction, and it is the best way to peacefully decide who gets what in a world of scarcity.

Because human wants always outstrip available resources, all societies need some sort of guidance for allocating what is scarce.

One solution is to have a few people centrally control these decisions. To varying degrees, this is the solution pursued by socialism in its different forms, but bitter historical experiences have demonstrated it has a couple of problems.

  • First, it concentrates power in a few hands, and excessive power tends to corrupt.
  • Second, those few individuals in charge don’t have enough information to orchestrate something as complex as a large market.

These twin problems have bedeviled every centrally planned economy in history.

Fortunately, there’s a better strategy for allocating scarce resources—the network of prices that arises organically from voluntary exchanges among buyers and sellers in the market.

Here’s how it works: A lower price for a good signals relative abundance and allows people to buy more of it. A higher price signals relative scarcity, prodding consumers to economize their use of the good while simultaneously encouraging producers to make more of it.

One caveat: a business’s social obligations reach beyond making a profit. Business owners and managers must deal honestly, keep their word, serve the community in a broad sense, and tend to the moral dimensions of the investment process. The price system doesn’t magically guarantee moral behavior.

But would dispensing with the free market magically erase the problem? It isn’t that easy. Moving to a purely socialist economy won’t remove lust and selfishness from the human heart. In fact, in a socialist society, the state would feed these vices—with the added problem that poor families have even fewer ways to earn a living because the socialist economy has placed various morally preferable enterprises beyond their reach.

Now some may concede that profits play a legitimate role, but then complain about “excess profits.” But what constitutes excess profit? Did Thomas Edison profit excessively from his lucrative invention of the light bulb, an invention that has enriched the lives of billions around the world?

More than this, large amounts of profit serve a useful signaling function. High profits announce that people want more of some good or service and attract entrepreneurs and resources to eventually meet that demand.

Notice too that the competitive bidding for resources and customers means no one is automatically in a profitable position. A business will only go on earning high profits through a combination of hard work, creativity, and vision, which in turn allows it to deliver value much more effectively than its competitors. This market dynamic constantly fuels innovation, since companies are constantly looking for new ways to deliver value more effectively than their competitors in order to realize higher profits.

Where unusually high profits persist for a long time, this is usually a symptom of something hindering market freedom. If new producers are not entering a field that is providing outsized profits, it’s often because of government restricting competition.

What do we do about this? The solution is to remove government from the business of picking winners and losers in the market—to move away from government cronyism and toward free and transparent capitalism. It is through this system that we can all fairly and honestly benefit from the transactions and profits of everyone.

 

Editor’s note: This post was adapted from Rev. Robert Sirico’s chapter entitled, “The Moral Potential of the Free Economy,” a chapter in For the Least of These: A Biblical Answer to Poverty.

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On “Flashback Friday,” we take a look at some of IFWE’s former posts that are worth revisiting. This article was previously published on Mar. 13, 2014.

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