Chapters:
- Introduction
- Price System and Voluntary Exchange
- Property Rights, the Rule of Law, and Contracts
- Helping Others and the Profit Motive
- Conclusion
- Glossary
Helping Others and the Profit Motive
When you invest in something, whether it is time or money, there is an expectation that it will be worth it to you in some way. Economists refer to this - no surprise - as a return on investment. For example, if you receive $100 from your aunt for your birthday, you may want to invest some of it toward your first automobile. Alternatively, you invest 10 hours in an assignment for social studies. You likely expect to receive a good grade on it. Businesses have a similar expectation of a return on investment. One way a business measures its return on investment is profit.
Profit is money that is left over after all the costs a business incurs are subtracted. For example, consider our pizza company in a prior chapter. Assume it earns $1,000 in a single day selling pizzas. The store owner had to buy $200 of ingredients and pay its employees $300. It also has to pay one day's worth of pizza oven cost, rent, electricity, and gas. Let's assume that is another $300. This leaves a profit of $1,000 - $800 = $200.
Profits are important for a business to grow and prosper. Recall that one of the incentives to use resources, such as private property, in the most productive manner possible is a source of value. Profit is a means to measure that value and is a reward for increasing its value. When resources are not used productively, a business may not cover its costs. When costs are not covered, the business incurs a negative profit, or loss. This can also happen when a business fails to serve its customers in a manner that they value more than alternatives. (For example, one supermarket in your town is often dirty, and doesn't offer as many choices as another supermarket. Which store are you more likely to shop at?) Remember opportunity cost from the introduction? You can think of a loss as a penalty for reducing the value of resources.
Profits - and losses - act as a signal to businesses. Profits suggest to producers that productive uses of resources can improve the owners' well-being. As profits from producing a good or service increase, more businesses may rush to create that product or service to earn profits. Milton Friedman suggested the only obligation a business has is to use its resources in a manner that maximizes profits, provided it follows the rule of law. It is possible that profits can make people and society better off, as well. This is because a business that is profitable and pays its employees well allows them to satisfy higher level needs. In other words, as a person's wealth grows and basic needs are satisfied, they turn to social needs which may include philanthropy.
Check out this video regarding how a farmer turned a loss into a profit:
Of course, individuals who do not own a business can also earn a profit. Remember how Beth wanted to sell her Beanie Babies to pay for a new iPhone? Assume the original cost of her Beanie Babies was $5 each and she has 100 of them. She found a buyer on eBay who will pay $600 for the whole collection. Her profit is $100, and she now has $600 to buy a new iPhone.
Businesses prefer to hire employees who help them efficiently produce goods and services. Efficient production involves maximizing quality and output while minimizing costs. The primary cost of employees is wages, with a second cost of benefits. In order for a business to earn a profit, the revenue it receives from selling goods and services has to more than cover costs. Remember, these costs also include such things as utilities and rent. The businesses also must serve their customers well, as Professor Jay noted. Otherwise, they may lose sales - and revenue - to their competitors.
When it comes to hiring an employee, a business will consider how well the employee will help generate additional revenue to cover the cost to hire him or her. Part of the value of this employee comes from the employee's willingness to work hard. Value also comes from the potential employee's knowledge, skills, and abilities. If an employee has few skills, inadequate knowledge, or insufficient abilities, he or she will receive lower wages than others who have higher levels of these. Interested employers bid for potential employees who possess high levels of knowledge, skills, and abilities by offering higher wages. Think back to the supply and demand concepts previously noted. Employees - as suppliers - are willing to supply more of their labor at higher prices. At the same time, employers may demand less of the labor as the prices rise. The equilibrium price of a wage is the one that intersects the supply of and demand for the labor. If employees demand too much in wages relative to their knowledge, skills, and abilities, employers may look to automation to replace employees. They may also eliminate a product or service if the higher wages would result in customers not seeing value at the margin.
Notice how the interviewer describes to Beth what his business does, how it adds value to its customers, and how employees contribute to the value. The discussion involves an exchange of words in which both parties attempt to determine what value, if any, Beth can bring to the intern position:
Each person seeks to satisfy needs. Since things that satisfy needs are limited in supply, people have to choose according to some priorities. How well a product or service satisfies a need - or value - is one way to do this. In a free market where buyers and sellers are free to voluntarily trade with each other, price is one way to observe value. When that service involves knowledge, skills, and abilities an employee can provide for employers, the value of them depends on how well the additional costs of employing the person are covered by additional revenue.