We've said before that businessmen are aiming to maximize profit, but we haven't really
gotten into the question of not so much what profit is or what explains it and therefore
what justifies it. Where does profit come from? Why is there profit? What are the economic
functions that it performs, etc.? First, profit is defined as total revenue minus total cost,
and then if we're interested in the ratio, it's that over, say, total investment or
The first thing to be done about profit is to separate profits into two very different
kinds of returns, both of which are amalgamated into the accounting concept of profit.
In other words, what is profit on the books of a firm really includes two very different
kinds of returns, two very different kinds of reasons.
The long-run profit does not mean it only appears in the long run, it means that long-run
profit is sort of an underlying return which capital investment sees as a sort of a continuing
vector in the day-to-day situation.
So that's long-run profit, which as we'll see tends to be uniform throughout the system.
That is not uniform, but tends to be uniformity, it's an important distinction.
And the second category is short-run profit, which comes from completely different reasons
and could well be and often is short-run losses.
So we have what is called the profit and loss system in the economy, much more accurately
than the so-called profit system, because of course there are many firms that do make
losses.
I think, for example, heroic entrepreneurs happen to be my uncles who were pharmacy store
Capitalist entrepreneurs back in the thirties. They had a chain of, I think, two or three
drug stores at the height of their entrepreneurial career. They quickly went bankrupt, not just
because of the depression, but because there were many other forms of the door that did
not go bankrupt. At any rate, they went bankrupt, revealing themselves and themselves into the
world at large, those who were interested, as lousy entrepreneurs, after which they entered
the ranks of the proletariat, in quotes, in other words, became wage earners.
So, entrepreneurs often do suffer losses. This can easily be seen in one form of entrepreneurship,
it's quite obvious, namely, purchase of stocks and commodities, where, again, some people
are good entrepreneurs, some people are bad ones, and we'll see in a minute what accounts
for this. The short-run profit, the whole realm of short-run profit and loss was unknown
Welcome to 19th century economics, and there are many things, when I say that I mean all
19th century economists, both Ricardo and Marx and also the Austrians, my particular
favorites, they did not analyze, they did not explore the realm of short run profit
and short run losses.
Their eyes were fixed largely on long run considerations on so-called equilibrium situations.
By equilibrium again, I don't mean day to day equilibrium, but long run equilibrium,
and also called evenly rotating economy or final equilibrium, and so they're interested
having their eyes on a longer or larger picture, they tended to ignore short run considerations,
they figured that will all wash out in the long run, but of course the short run doesn't
wash out because there's always a series of short runs as we'll see as we go along, the
short run is always with us, it's always dominant, but the 19th century economics left this out
of the Picture, and therefore left a very essential part of the explanation of profits
out of their analysis. It was Frank Knight, who was the founder of what we can call the
older Chicago School, the economist at the University of Chicago, who wrote a famous
and brilliant PhD thesis, one of the top two or three PhD theses in the history of economic
thought, Risk Uncertainty and Profit, which came out in 1921, where Knight single-handedly
He brought the analysis of short-run profits into the picture and came up with the correct
solution.
He also messed up completely the theory of competition, but that we get to another time.
In the theory of profits, however, Knight came up with the definitive formulation that
he didn't deal with long-run profits at all.
He dealt with it unsatisfactorily, but really not much at all.
He dealt with a short-run and close situation.
What he said was that profits, in the short-run sense, arise from uncertainty, the fact that
the world was uncertain.
See, the problem is that most economists in the past tended to think of the world as more
or lessividely certain.
In other words, you look at the situation, you say, well, we more or less know what the
future is going to hold as far as demand goes and costs and so forth, which of course leaves
out an essential part of the picture, which is that the world is uncertain, that supplies
and then they go up and other people buy stocks and then they go down.
This is not, however, a scientific, which we'll return to, it's not a scientific, it's not an applied science of forecasting.
If it were, it would be like forecasting the comets and sort of thing.
Instead, it's a high art because it involves not only your knowledge, general knowledge,
it also involves detailed insight into the market and what's going on,
and your specific knowledge of concrete events, which often keep changing, so you have to sort of also involve punches and involves personal entrepreneurship or personal artistry, which some people have and some people don't.
What it involves again is seeing gaps in the market. In other words, what you have really, in the long run, touching on long run profits, in the long run, profits will tend to be the same.
In other words, posing the Angel Gabriel came down and says to the earth, I'm going to turn to Angel Gabriel later on as a convenient hypothesis, Angel Gabriel comes to the earth and freezes everything, in other words, he declares a freeze, much more expensive than the Nixon freeze of Orga 71, he freezes all value scales, everybody from now on will have the same value scale, all resources are frozen, so that any copper taken out of the ground will sort of magically be restored, all technology is frozen. Given that, given the
The freezing of all consumer demands, the consumer value scale, given the freezing of
supply, so that an old stonemason dies, he's magically replaced by a young stonemason,
so forth and so on.
Given this kind of model, then in a few years, which would have the following situation,
you would have, for example, certain industries that are making 30% profits, others are making
suffering losses.
This means that capitalists will enter the profitable industries and get out of the losing
industry.
The point is, when you freeze everything, you see the conclusion of all this.
They'll flood into the superior, the profit-making industries.
As they flood into the high-profit industries, production increases, supply curve shifts to the right, the price falls, costs are bid up, wage rates, raw materials, et cetera, in that industry.
And you wind up, eventually, in a couple of years, let's say, with a uniform profit rate.
What the uniform profit rate is, what it comes from, we'll get to later on.
Let's say it's 8%, just for the heck of it.
So we'll get to the uniform 8% and stop. In the meantime, those firms that are now in the capitalist, investing in the losing industry, say the hula hoop industry, now the hula hoops are more or less defunct, we'll get out of there, stop making losses, move into other profitable industries, and whatever hula hoop firms exist, if any do exist, we'll also be making 8%. There's still a couple of horse and buggy manufacturers. They're not very big. They make, say, horse and buggies for Central Park horse and buggy market.
Presumably they're making the usual uniform rate of profit.
So you wind up then, if you freeze everything, if you have this magic permanent freeze, you
wind up with a uniform profit rate throughout the whole system.
Every firm, every industry is making this long-run normal rate of profit.
And I say, we'll get to later what determines long-run normal rate of profit, why it exists
in the first place, etc., etc.
Right now we're focusing on the fact that short-run profits tend to disappear given
a freeze, in other words, given certainty.
If you know that there's a freeze, if you know that the freeze will persist forever,
then you have certainly what the future will lie, you know with certainty what future consumer
demands will be, what future costs will be, etc., and then you make your changes and you
wind up, after six months, two years, whatever the time period, after this time period, you
wind up with an evenly rotating economy where everybody's making, every firm is making
up 8% or 6%, whatever the uniform rate is. In other words, short-run profits and short-run
Profits and losses are wiped out. Obviously, the reason we have persisting short-run profits
and losses and why they keep changing all the time, fluctuating, appearing, popping
up here and there, is because we don't have certainty, we have uncertainty, we have changes
all the time, and all of these factors, changes in consumer values, changes in resources,
changes in technology, etc. So what the function then, the profit maker, is engaged in a forecasting
and Function.
It's forecasting plus investment.
I mean, forecasting with a bite, so to speak.
It's not just forecasting as an abstract sociologist.
It's forecasting with a pocketbook.
He's investing money, and by doing this, he's forecasting where he thinks he will make a
profit and not make a loss.
This is not determined in advance.
There's no guarantee that he's not going to make losses.
There's no guarantee he'll make high profits.
It all depends on his superior forecasting, in other words, forecasting better than his
competitors.
In the stock market, where it's clear this is what happens, the superior forecasters make
heavy profits, the mediocre forecasters sort of peg along, break even, the lousy forecasters
go out of business eventually and make severe losses.
What you have then is the entrepreneur, in quotes, in other words, the capitalist as
entrepreneur, as undertaker, so to speak, as risk taker, as uncertainty bearer, gains
profits from superior forecasting. Superior forecasting for what? Superior forecasting
and the best ways of meeting the most urgent consumer demand. In other words, the superior
forecasters, he looks at the market and he sees, aha, there's not enough, whatever it
is, tungsten production, let's say. If I go into the tungsten business and I open up a
new tungsten mine or produce more tungsten or whatever, I'll be able to make high profits
because they're not making enough now to satisfy consumer demands. He might think of a better
way of producing tungsten. He might invent a new process or his brother-in-law might
of a New Process, finances, or whatever. Again, he sees better than the other people, better
than his competitors, where there are gaps in the market, where there are profit opportunities
to be made, and then nips in to fill them. By filling these profit opportunities, he
is increasing consumer welfare, because what he's doing is he's filling these gaps. In
other words, he's kind of zipping in there to take advantage of these high profit opportunities,
by directing production into those areas where consumers most urgently demand further resources,
further production. So in other words, higher profits are an indicator of a superior, not
only forecasting ability, but a superior ability in satisfying consumer, urgent consumer needs
as quickly and as efficiently as possible. Low profits or losses are an indicator of
for having wasted resources, being a lousy forecaster, have invested in areas where consumers
either did not want the product too much, or there was a low demand for it, or invested
in an inefficient manner.
For example, this is only what the government can do because the government has no compunction
as not to suffer losses because the taxpayer picks up the tab, is forced to pick up the
tab.
There's the famous British groundnut scheme in West Africa about 20 years ago or so when
The British government invested or caused to invest in an enormous acreage of peanuts,
known in England as groundnuts. Some joker had the idea that the West African soil, whatever
is suitable for peanuts, is an enormous investment, all of which went down to two. Usually private
entrepreneurs don't do this because they have to be very cautious about investing correctly,
which governments don't. In other words, there's all sorts of losses or embodiment
of Malinvestment. In other words, the embodiment of the fact that the guy has wasted resources.
So we have a very peculiar situation. And another thing I should say is that the high
profit person, the firm that earns high profits, is pointing the way toward other firms to
get into this industry. In other words, if let's say there's a firm invested in Tungsten
and has a high profit in there, he's sort of pointing the road and saying, look, here's
an area with a big gap in the market, big gap in filling consumer demand, and this is
In the other hand, of course, the guy who loses money in peanuts is an indicator in
a beacon light to other capitalists, stay out of peanuts, this is not the place to invest.
So therefore, the profit maker of a capitalist who earns these profits from superior forecasting
etc. is performing an enormous social service to the consumer, in addition to making profits
And yet we have a peculiar situation in the current culture where the profit-maker is
bitterly attacked and the loss-maker is slobbered over by writers and lecturers, etc.
So in other words, in the current energy crisis, the oil companies are bitterly attacked for
earning high profits.
Instead of saying, hey, this is a great thing that you're earning high profits, an indication
of being in an area where consumers need more stuff and we hope that other people will join
in this great endeavor, producing more oil. Instead of that, we're attacking oil companies
for the fact that they're making profits as a sign that somehow they're evil. On the other
hand, we have other companies which are suffering losses chronically, say Lockheed or Penn Central,
and the government and intellectuals feel compelled to rush to their defense, to subsidize
them, to keep them floating forever, and thereby, of course, subsidizing their constant waste
of resources, waste of land, labor, and capital, which would be better used, let's say, in
and Oil, or some other profitable industry.
So we have this peculiar situation where the people who make losses are weeped over and
subsidized, whereas the people who make profits are culminated and profits taxed away or they're
hobbled in all sorts of ways, thus of course penalizing efficient service of the consumer
demands, consumer needs, and subsidizing inefficient and crummy service of consumer needs.
It doesn't make too much sense, except of course if you want to smash the system altogether.
Okay, so this is the function of the so-called short-run profit.
As a marvelous illustration of the function of the entrepreneur and what the entrepreneur
does in one of the great Somerset and More movies that appeared about 25, 30 years ago,
I forget whether it was Trio or Quartet, one of these short subject things.
And one of them was Morem's great short story called The Verger, and it's a charming story
I want to tell you about this fairly elderly fellow who was a verger, in other words, a deacon, no, a sexton, I guess, at the St. Paul's Church, a small church in London.
A new pastor comes in and wants to make the place efficient and rev it up. He finds with horror the sweet old verger performing his duties with great diligence, etc.
He finds out this guy can't read. He says, this is a terrible thing. You're illiterate.
What a shame this is for the community to have a verger of this great church that can't read.
So he tries to force him to learn how to read and write, and the guy says, yes sir, I'll try to learn, but he can't do it, he can't read or write. Sorry sir, I'm too old.
And so the pastor kicks him out, gives him a terminal leave, and he's walking the streets, very disconsolate, and here he is in fire, and he's 55 years old, whatever he was.
He's walking the streets, he feels the need for a cigarette, he's pacing, he's walking down the streets of the neighborhood, looking for a tobacco in his shop, can't find one.
He tells me you should go to open up a bank account, let them invest for you, etc.
So he goes to this bank, he plops all his money on the desk, there's almost no money on the desk.
And he says, I'd like to open a bank account, etc.
He says, yes, yes, sir, of course.
And the bank manager gives him the forms to fill out.
And he says, well, just sign your name on this form.
He says, sorry, I'm going to make an X.
Why are you making an X? Because I can't read or write.
The bank manager looks at him, astonished me, he says,
My God, man, where would you be today if you only knew how to read or write?
If I know where I'd be, I'd be the verger at St. Paul.
This not only shows the entrepreneurship filling the gap of the market,
it also shows that reading and writing, or a Ph.D., or whatever,
is not necessarily a royal road to successful entrepreneurship.
There are indeed lots of illiterate millionaires still roaming around who do very well, Lebanese
importers and that sort of thing, who do very well even though they can't be here right.
Again this indicates that successful entrepreneurship is an art rather than some kind of an educative
science which you can go to school and learn.
Okay, so I think we can see the profit and loss element in profits, that the short run
Long-run profits and short-run losses see the social function that they perform.
What about long-run profits?
Now long-run profits, they were the things that were focused on in the 19th century.
Long-run profit, for reasons which we will come to, can also be called a rate of interest.
Capital earning a rate of interest in the long run.
Why is there such?
First of all, would there be long-run profits?
Some economists have denied this.
Some economists claim that in the evenly rotating economy, in this long-run equilibrium situation,
Profits and losses would both be zero. Obviously losses would be zero because nobody is going
to invest. They knew they were going to make losses. That's pretty clear. So if you had
a world of certainty and you had this equilibrium situation, nobody would make losses. But the
contention of many economists is profits would be zero also. I deny this and also I think
many other economists do too. There's another thing to be explained here. Can't just use
a nice explanation of entrepreneurship and short-run profits and losses and uncertainty.
has also other stratum of 6%, 8%, 4%, whatever the percentage happens to be, which will tend
to exist even in a world of certainty, even when there is no list to take, even when you
know what the demands and costs will be forever and the technology forever and ever.
Now the reason, of course, we're interested in this long-run equilibrium model, although
most microeconomics is only interested in that, the reason why I am interested in other
so-called Austrian economists who are interested in this equilibrium model is as a method of
separating long-run and short-run and trying to figure out the explanations of both of
them and also to see where the economy is tending because even if things are not frozen,
of course they are not, we can say that while the economy is always tending in the direction
of this equilibrium, even though it will never reach it, and it's not a great thing if it
could reach it, it would be pretty miserable, that it will never reach it, it's a way of
explaining direction and tendencies in the system.
I like to think of the analogy I like to use as a dog chasing a mechanical rabbit, an economy
The economy is a dog, long-run equilibrium, a uniform rate of profit throughout the system
is a mechanical rabbit, and the mechanical rabbit is always changing direction in a sort
of unpredictable manner, and the economy tries to, the dog tries to follow it.
It sort of, it leads you to be able to explain the tendencies in which the economy is going,
but it will never reach because the angel Gabriel has not come down to freeze values,
resources, and technology.
If the angel Gabriel did come down and freeze it, then we would after a couple of years
wind up in this kind of evenly rotating and long-run equilibrium system.
Okay, so among one of the components then, we talked about short-run profits and short-run losses, forecasting and uncertainty.
What about this other vector, this other long-run profit? Where does that come from? What's the explanation for it, etc.?
It's that profit, the long-run profit, for example, that Karl Marx was attacking as surplus value is illegitimate,
is extracted from workers' wages and so forth.
To be more specific, in the long run, labor earns wages, and wages are determined by the marginal productivity,
the marginal revenue products we've seen of workers.
Land earns rent, which is also determined by the marginal revenue products.
We can see how that happens.
What about capital? Where does profits come in?
Or where does the long run profit or interest come in?
We'll see a little later why it's called interest.
The easy answer for this, and the answer to the so-called productivity theory, probably invented by a nationalist senior, the great English 19th century classical economist, which is still in the textbooks, by the way,
the easy answer goes as follows, and it comes from this triad, which is really a legitimate triad, of land, labor, and capital.
Three kinds of factors of production, labor earns wages in accordance with the marginal productivity, land earns rent in accordance with marginal productivity, and capital, in quotes,
machines, equipment, buildings, all these man-made factors of production, earn profits,
earn rate of interest, because of its productivity.
And usually this sort of productivity explanation is, well, after all, since capital machines
are very productive, they're very important in production, therefore, machines have to
earn something too, so therefore, that machines get this rate of profit.
And you'll see, for example, in most textbooks, this sort of diagram, the economists will
We'll start with the marginal product productivity theory, wind up with this sort of thing, usually
in the labor market.
Say, okay, in the y-axis there's wage rates, in the x-axis there's purchase of labor, purchase
of the factor, hiring.
And the demand for, and there's a supply curve and demand curve, the demand curve for labor
is equal to the marginal revenue product, marginal productivity.
Then the next chapter or the next diagram, the author says, okay, in the same way capital
Capital earns interest. Instead of having wage rates on the y-axis, you have interest
suddenly pops up and then you have capital hired or purchased and then you have a demand
curve for capital or a demand curve for machines or whatever, which is supposedly equal to
the marginal revenue product, which then determines the interest rate. There's lots of problems
with this. The first place is a tremendous equivocation of the word capital. There's
two different uses of the word capital. As capital as a fund is available for investment
Capital Goods, Machines, Tools, Buildings, Trucks, etc., etc.
The problem with this is, it looks pretty easy.
The economist then wraps the whole thing up, and that explains profit, and you go on to something else.
The problem here is that interest has nothing to do with wage rates.
It's not analogous at all.
The analogous thing for capital is the price of the machine, or the price of a building, or whatever.
So where does interest come in?
In other words, the genius also earns its marginal revenue product, gives it a price.
If the marginal revenue product of a machine is, let's say, $10,000 a year, let's assume
for a while, for various, to simplify matters, that nobody buys a machine, I'll get back
to buying machines later, let's assume everybody rents a machine, there's machine producers,
there are capitalists who produce, and then other people who rent the machine out, assume
they're all rented, and then the marginal revenue product of the machine, let's say,
is $10,000 a year, the question then is, why is it not that the capitalist who rents the
Why doesn't he have to pay $10,000 for it?
In other words, this should be $10,000 here on the intersection point.
We should wind up with the price of the machine being $10,000.
In fact, it isn't.
The point is, in fact, that it's lower than $10,000.
The price of the machine is, let's say, $9,000,
which means that the guy who rents the machine,
the capitalist who rents the machine from the producer,
earns a 10%, let's say, interest rate.
It's usually less than that.
Let's say it's 10%.
That's it. Simple.
Something like 10%.
The question then to be discovered, you see, in other words, the modular productivity theory doesn't explain interest, the existence of interest or long-run profits at all.
What it explains is the existence of a price for a machine that you have to pay a certain amount.
So where does interest come in? The answer is it doesn't come in yet.
So the productivity theory is not an explanation at all of the interest rate.
So then the thing to be explained is why is there, why is it not the price bid up to 10,000?
In the same way, wages and land rents are also discounted in a very similar way, so
that we wind up with wages and land rents all discounted by an interest rate, by let's
say 10%.
That could be 6%, and all the time what the interest rate happens to be.
So then the question is, how come permeating the system, we have an interest return for
for Capitalists.
Totally apart from forecasting, from risk taking and all the rest of it, why is it wages
and land rents and capital and machinery are not bid up to their full margin of revenue
product?
Put it another way, Karl Marx pointed out that the laborer had to pay a surplus, had
to pay a profit rate to capitalists.
One of the answers to this is, well yes that's true, on the other hand also land has to pay
a profit rate and machines have to pay it.
you wind up with this discount going all the way across the board
then the question is why are they willing to pay it?
because they obviously are, why is it that the market winds up
and the free market winds up with this sort of payment being made
this call of exploitation doesn't really answer the question obviously
and also we find out that this productivity theory doesn't answer it either
what we had is that the answers to the
Marxian or the other taxon profit
were not satisfactory throughout the nineteenth century
the answer finally came
was one of the greatest economists in the history of economic thought.
Eugen von Boehm-Bawerk has a great work, Capital and Interest, which came in as a combination
of the older Austrian school and the middle 1880s.
But only Boehm-Bawerk really sort of copper riveted the explanation.
It came up with the answer to this whole puzzling question of where long-run profits come from,
or interest rates come from.
One way of introducing this Boehm-Bawerkian solution is that you rent out a machine and
When you produce it over a year and you earn the 10% or 6% or whatever, the key thing wrapped
up in this whole thing is time.
In other words, time is a key element in the earning of interest.
Or, to put it another way, part of the Marxian critique, he said, well, it's true that capital
goods are productive, they're very important.
However, capital goods are themselves produced, they don't drop from the sky, they're themselves
produced by land, labor, and capital.
If you push the whole thing back, logically capital drops out and you're left with only
labor and land.
And what Marx said is that therefore labor should get the entire income, the entire product.
Of course, if you add, since he ignored land, which you have to do first of all is add land
into the picture and say labor and land should get the whole product.
And then you have to say, well after all product takes a long time, so the time in some way
enters then.
You wind up instead of saying, as Marx does, the capital goods are frozen labor or embodiments,
frozen embodiments of labor, which should modify that and say first place, okay, first
place we have to include in labor management, entrepreneurship, decision making, entrepreneurship
in the short run uncertainty. So in other words, the president of General Motors would
also be a laborer. And second of all, aside from that, it's also frozen land and it's
also frozen time. And then we'll see that the key to the long run rate of profit is
precisely this whole time consideration, our so-called time preference. Before I get into
more into that, I want to put on the board a great diagram which has dropped out of current
The so-called structure of production concept, which von Boehm-Bawerk and the Austrian School introduced to the world.
Orthodox economics today, capitalism is treated as one big blob, a homogeneous lump.
And so there's all sorts of measurements, supposed measurements of capital output ratios and so forth and so on,
and there's a statement that all you need to increase production is more capital,
which leads to things, for example, like the government investing in underdeveloped countries, say government investing in a steel mill,
We start with consumption on the lowest level.
Consumers, let's say, spend $100 billion during the year on retail stores.
So you have $100 billion going from the consumer to the first stage of production, which is
the retail industry.
Designate this by a bar, $100 billion is the length of the bottom.
So money is going up this bar, in other words, money is going from the consumers to the retailers
and goods of all sorts are going down from the retailers to the consumer, that's the
first bar.
Okay, the retailers now have a hundred billion in their pockets and what are they going to
do with it?
Well, most of it of course goes to the wholesalers to buy the inventory and so forth, but a certain
amount gets siphoned off to the people in the retail industry, let's say ten billion,
So 10 billion goes off to function as income. In other words, to wages, land rent, interest and profits.
So we have 100 then going to the retail industry, 10 billion gets siphoned off, and the other 90 billion goes to the wholesalers.
Now we have another bar, the wholesale bar, which is however shorter, because 10 billion dollars have already been siphoned off.
The same thing that happens to the wholesaler. Here's a retailer, wholesaler. A wholesaler
is swiping off another $10 billion, let's say, and $80 billion goes to the jobbers to
get their inventory. And once again, you have $10 billion going to wages, land rent, interest
and profits in the wholesale industries. And then we go to the jobbers. The $80 billion
goes to, let's say, $90 billion and $80 billion. And we keep on going. We've got the manufacturing
and then the mining and the forming. And as we keep on going, in each stage of production,
Money gets hived off until finally, logically, you wind up with all the money going to personal
income.
This is the structure of production.
This is the latter kind of effect.
A lot of things happen here.
First place, a hundred billion gets hived off.
They have a hundred billion in personal income.
Then the consumers, the wager earners, the land owners, the capitalists, etc., take the
hundred billion and they might even invest it.
So let's say for a minute that they just spend it again, then they have the so-called circular
flow then, and the dollars get turned over as they go on up a ladder.
We have the structure of production, as the capitalist system advances, as more and more
capital gets invested, more and more the structure becomes higher and higher.
And here we have this enormous structure of capital which keeps increasing, and we'll
see when we get to the business cycle theory how this can be used very readily to explain
The point is, all this money gets hived off in income, and this of course endorses the
Marxian point to the extent, yes it's true, each stage of the way is produced by other
stages and you wind up with all the income, all the 100 billion, gets exhausted by each
step of the way, so there's no net profit accruing to capital machine producers, per
The Interest and Profits can't be explained by the, it's still unexplainable in this diagram.
Again, you can't explain the interest and profits by the purely productivity kind of explanation.
So what is the explanation?
Well, as I said, it's time explanation.
Each stage of the game takes time.
How does time enter in the picture?
Well, it goes like this.
The function of the capitalist, again, this is not talking about the manager or the entrepreneur,
it's talking about the pure capital function, the pure supplying of capital.
The function of the capitalist is this, he saves up money from previous profits or previous
income or whatever, the capitalist pays out money and pays money out to existing producers,
to existing workers and landowners while they're producing.
In other words, let's assume for a minute there are no capitalists, and it's certainly
Logically, there's no reason on the free market why you can't have a world of producers' co-ops,
of workers' and landowners' co-ops, or pure workers' co-ops, or whatever,
which have no capital function at all. There's no capitalists.
Everybody gets together and decides they're going to produce an automobile or whatever.
Supposing they do, why has this not flourished on the free market?
Because certainly on the free market, there are no laws repressing this kind of producers' co-op.
Well, producers' coffers have always been abysmal failures. They never have succeeded
worth a dime. The major reason is very simple. The workers say they're out to build tungsten
or they're out to build oil and be able to produce oil and be able to do whatever. It'll
take them quite a while to do it. In other words, the workers all get together and they
work on this thing. They get the landowners, et cetera, and they get the raw material.
Let's say, take them, let's say, three years, five years or whatever, producing oil and
be able. Five years, they ain't getting paid. They're hoping that they'll be able to sell
Hello Automobile is going to get on the market.
Now, aside from the risk function, which we'll get to, we'll get back to in a minute, everybody
understands the risk function, I think, pretty well.
There's a pure time problem here, it's our waiting, in other words, the sheer problem
of having to wait five years without getting paid, until the money comes rolling in.
So, while I'm concerned, I would not be able to last more than a couple of weeks without
payment.
And I think for most people, this is true also.
The function that the capitalist performs here, the very, very vital function for the producers,
the workers and landowners, is to give them money now, while they're working, every week
or every month, so they don't have to wait five years until the automobile is produced.
Who waits?
The capitalist waits.
In other words, the capitalist takes on the waiting function, and then at the end of the
six months or the five years, whatever the period of production happens to be for that
particular product, the capitalist sells the car and gets the revenue, and what does he
How was he rewarded for this? He was rewarded by the interest rate. He was rewarded by the rate of time preference.
So he is performing an extremely important and vital function, a function which everybody should love.
They really thought about it. It enables them to get money now instead of having to wait for five years until the money pours in.
For this service they pay the capital as a discount.
You have to modify, and this again you'll not find in the textbooks unfortunately,
You have to modify the marginal productivity theory to say labor and land and all the other
products, yet not their marginal revenue product, but their marginal revenue product discounted
by the rate of interest.
So the rate of interest, or the rate of long-run profit, is a willing exchange, since we realize
in contrast to the Marxist and the free market, exchanges are voluntary, so we have to be
some sort of function that this capitalist profit is reaping for this discount they're
Capitalists are getting, the function is precisely handing out money now instead of the producers
having to wait for it.
To put it another way, this is a time preference change, or a time market, very, very similar
as a matter of fact, economically, analytically identical to the credit debt change.
What's happening when a capitalist hires workers, for example, the capitalist has saved up money
previously, the capitalist is paying out money now, he's paying out a present good.
In other words, money is a present good, money is something which can be used at any time
in the present, any time a person wants to, you can spend it.
So this is the so-called present good, workers and landowners, etc., producers in general,
are getting the money now and in exchange for this, the capitalist is receiving future
good.
In other words, he's expecting, he's receiving a future income from the car or whatever.
In other words, he is changing a present good for a future good, and here we get to the
primordial universal fact of time preference.
Again, Boehm-Bawerk was the first one to really govern and analyze.
Time preference meaning, if you remember the old motto that a bird in the hand is worth
two in the bush, where the time preference motto says a bird in the hand is worth more
than one bird in the bush.
Forget about two in the bush.
The point is that a present good is worth more than the expectation of a future good.
Now, different people and different groups and different societies have different rates of time preference.
Some people have very high time preference.
For example, myself, just before the next paycheck arrives, I have a very high rate of time preference.
I've been willing to borrow at high rates for the three days or whatever it is as my money runs out, as my bad management takes over.
That's a high rate of time preference.
And then there are low rates of time preference with people who have great foresight and plan ahead for the future and so forth and so on.
So there are all sorts of different rates of time preference, just as with other marginal
utilities, there are all sorts of value scales in society, there are all sorts of value scales
for hula hoops and for doughnuts and whatever.
In a similar way, there are all sorts of value scales and relative marginal utilities for
time.
These time preferences get all intermixed in the time market, which spreads throughout
the whole system, which results in one single or tendency toward one single rate of time
time preference, which is a resultant of all these individual time preferences, just as
the price of hula hoops on the market is a resultant of all of the marginal utility value
scales for hula hoops.
So if everybody has a low rate of time preference, you'll have a low rate of interest, a low
rate of discount.
If everybody has a very high rate of time preference, you'll have a very high rate of
discount.
This is analytically the same thing as a credit transaction.
In a credit transaction, if I borrow $100 from my friendly local porn broker or whatever,
the creditor pays out present money, let's say $100 as a present good, to the debtor.
He's getting from the debtor, say from me, an IOU, a claim on some future good, money
in the future, say a year from now, and instead of paying $100 back, I'm going to pay more
More than that, I'm paying, let's say, $108, 8% rate of interest.
Why am I willing to pay the 108 and why is he charging the 8% and why am I willing to
pay it?
For the same reason, because both of us, and the society in general, faces this premium
on time.
So that in this situation, it's worth more to me to borrow now, it's worth more than
the 8%, so I will borrow.
He has lower time preference than I've got, in other words, within this 8% framework,
so he lends money to me.
The point then is, for both of us, and society in general, values present goods more than
future goods, values $100 now much more than the present value of $100 a year from now,
and therefore the rate will be set accordingly in the market.
Now sometimes the rate will be lower, if everybody's thriftier or more foresighted, the rate might
shift to 4%, full or 4% or whatever, other times it might rise to 20%, but whatever the
The rate is determined by the social time preferences of all the individuals in society.
One example of what Ludwig von Mises used to give is that the year 1000 approached.
Most Christians, the interpretation of the Bible was that the year 1000 Jesus would return
to earth and the whole world would come to an end and we would have the kingdom of heaven
on earth.
This is a millennialist view.
And so as you get to 998 AD, 999 AD, when most people expected the world would come
In the end of the year 1000, nobody is very anxious to lend money for a three year period
after that, to be returned in 1000 CAD, because it won't be of much use. As a result, the
interest rates began to go up. People really expect the world to come to an end, interest
rates would start going up to infinity, they really expected that. So as you get very close
to the point of day of Armageddon, the interest rates would zoom up to 10,000% a day or whatever
it would be. This would be a time preference rate.
The function of the capitalist is very similar to the function of the creditor. The capitalist
is supplying present goods, the creditor is supplying present goods. Instead of receiving
a fixed debt in return, he's getting another kind of future good. He's getting the car
when it's going to come off the assembly line and he'll be able to sell it. He's getting
the ownership of the car when it eventually emerges. In both cases, the economic function
is the same. What the capitalist is doing then, in the real world, he's performing two functions.
One, he's performing the short-run function of, hopefully, successful entrepreneurship
and forecasting, and forecasting changing future trends and meeting consumer demands
in the future, forming his entrepreneurial uncertainty function, and two, he's performing
his 8% function, he's performing his time function of supplying present goods and taking
on the burden of waiting for the future.
For this, as I say, the worker is happy to give him the 8%, at least they might think
The point is in action they are happy to do it, otherwise they wouldn't be doing it.
Otherwise they'd be forming workers' co-ops.
So the two reasons we can say why workers' co-ops have failed, one, because most workers
don't have the money to start in, to pay themselves out, they don't want to wait for five years
before they get paid, and two, because they don't want to take on the risks of losing
all their money.
They want to take on the uncertainty risks, both of which the capitalist assumes, both
the uncertainty bearing and the weighting burden. So that we have a selective sort of process
where the capitalist entrepreneurs tend to be those who are most able to do both of these
things, weight and forecast the future. So now we see a vision, so to speak, of the economic
system, looming up, where the consumer goods prices are determined by values of consumers,
In other words, it's too much value scale by the marginal utility and the law of diminishing
marginal utility.
Producers' goods prices, in other words, wages, land rents, machines, etc., are determined
by marginal revenue product, the marginal productivity, set by the marginal productivity,
and going through this whole system, discounting all the marginal productivity, whenever there's
time involved, there's a rate of interest or a rate of time preference, where the capitalist
earns the discount.
So, as I say, von Boehm-Bawerk was the one who cleared up this problem. There's another
similar problem, an addition to the Marxian problem, which Hornswoggle eventually laid
low Catholic scholastic philosophers. Catholic scholastic philosophers, not only in the Middle
Ages, but also much later than that, in the late 16th, 17th century, were extremely brilliant
social analysts and also economists. And they analyzed, first of all, one of the reasons
This hasn't been discovered until about 20 years ago.
They all wrote in Latin, and you know how many people read Latin now.
Nobody reads them, and nobody read them for a long, long time.
And it turns out that in Book 12, there's some theologica or something.
Here's a very sophisticated analysis of the market.
They understood much about the market.
As a matter of fact, they almost discovered marginal utility.
They didn't quite do it, but they almost came up to that point.
But there was one thing that they completely flubbed on, which later discredited them,
And that was, they couldn't understand, they couldn't understand about risks, they couldn't understand why people would be risk-bearing and get a profit, they couldn't understand about making money on a risky investment, they couldn't understand about all sorts of stuff about profits, they could never understand about time preference, they could never understand the legitimacy of charging interest rate on a pure consumer loan. So they call this usury. Their analysis was, well, taking from Aristotle, which they were very good Aristotelians, they said, well, Aristotle says that money is a dead thing.
It's not moral. It's sinful to charge any interest whatsoever on a pure loan. And they call that usury. Now, we think of usury now as somebody charging 28% per day interest. But usury, the technical definition of usury is any interest whatsoever, because this is the philosophical problem the classics had.
And so the church, taking off from this, condemned usury for almost until about the middle of
the 19th century or so.
Now there were many problems involved in this, it meant that if you say that all interest
is illegal and immoral, everybody started evading it, even very good Catholics started evading
it.
So they started discovering that the scholastic philosophers themselves would ratify all sorts
of devious ways of getting around this prohibition, they had all sorts of things like forward
Market and Foreign Exchange, those of exchange, maneuver it in such a way that you'd be charging
interest but not saying it, pretending it's only a foreign exchange market.
And also the very sophisticated devices, the church itself and its loan money charged interest,
was therefore engaged in the sin of usury.
So this whole usury thing, the spread of at least the economic analysis of the scholastics,
was partly responsible for the decay of scholastic philosophy in general.
The problem was they never discovered time preference, so they didn't have Boehm-Bawerk
The problem in other words being that, yes you are performing a function by lending out
money, you're giving somebody money now in return for future money, in other words you're
giving them a present good, you're satisfying their time preference, their desire to have
money now instead of the future, this is just as important as any other service, therefore
nothing will charge interest on it.
However, as I say, they hadn't, they didn't ever discover that.
The other thing I should say here about wages and land rent, the theory of rent, which again
was discovered by Frank Fetter as one of my favorite economists, Austrian School economist
of Princeton Cornell in the 20th century, who built on Boehm-Bawerk time preference,
purified the time preference theory of Boehm-Bawerk, kicked out the productivity stuff I've been
talking about.
More clearly than Boehm-Bawerk did, because Boehm-Bawerk kind of fudged a little bit till
the end.
Also, a very interesting theory of rent, saying that after all, rent is not just land rent.
What really is, is very similar to renting out.
In other words, it's a common sense view of renting a tuxedo or renting a house instead
of buying it.
So we have two different things here.
Rent then becomes a charge for a service per unit time, rent per hour, rent per month,
rent per year, etc.
In English Classical Economics, in the old days in England, very few people, aristocratic
families didn't sell land, they only rented it out, so you think of land only in terms
of rent. What really happens is that every good and service, every labor and wages, land
and rent, machines and so forth and so on, every productive factor earns a product, productivity
per unit time, and this is there, it's rent. In other words, if a machine is worth $10,000
a year, it's going to get $10,000 a year in rent, minus the rate of interest. This is
and so rents then permeate the economy, not just for land but for everything.
We can then look on wages as also a rent.
A laborer sells his services per unit time, he doesn't sell his body, except under slavery.
Absenting slavery, then, you can only rent yourself out, you can't sell yourself.
And so wages are also a rent.
You don't have only really two forms, in a world of certainty, there are only two forms
In the world of income is rent and interest. In other words, every productive factor earns
a rent, whether it's labor or land or capital goods. And then finally, the capitalist earns
a discount, which is the rate of time preference and rate of interest. And then, of course,
in the world of uncertainty, we have profits and losses, short-run profits and short-run
losses. So that rent then becomes a universal kind of productive income in which everybody
in a sense earns. And we can see this. One of the problems is that economists haven't
I'm going to analyze the economics of slavery. Slavery is a fascinating institution from an economic point of view.
How could I want to restore it for that reason?
Because under slavery, for example, in the South, sometimes slaves were sold and sometimes they were rented out.
So, in other words, the slave then became a slave master, treated the slave as any other capital,
and so the slave was often rented out to other capitalists seasonally or whatever.
Okay, so we've explained consumer goods prices, we've explained profits, wages, rents, marginal
productivity, interest, time preference, etc., and even short-run profits.
There's one thing left to go, really, in this explanation.
We've explained the rental price of labor, or the rental price of the land, or the rental
price of the machine, but not the price of the whole good.
Where does that come from?
Presumably it's some sort of relationship.
If a slave could be rented out, say, for $1,000 a year, the sale price of the slave must have
The capital value applies not just to that, it applies to everything. It applies to land, it applies to people under slavery, it applies to anything which can be owned.
What's the capital value of a house or a machine or whatever?
Well, the first approximation is it will be the sum of expected future returns, or in our terminology, expected future rent.
Let's say you have a machine which you think you can rent out for $10,000 a year, and it's a 10 year life.
So in that case, you expect a return now of $10,000 over 10 years, and a total return of $100,000.
So therefore you might think the capital value, if you're going to sell the machine,
you'll be able to get on the market $100,000 because that's how much the guy will get in return.
That's the first approximation. However, of course, it's wrong.
The reason why it's wrong is because you have to discount the expected future returns by
what?
By the rate of interest.
So you have the discounted sum.
You have this machine.
You're thinking about buying this machine.
You know that after 10 years it will give you $100,000.
Let's say you know that.
Your value that you place on the 10th year of $10,000 is a lot less than on today's $10,000.
And the discount that you'll charge, that you'll consider or estimate it at, is the
rate of interest, the going time preference rate and going rate of interest.
Let's say it's 10% to make it simple. In that case, let's say you're getting the money in now, just to make it for the first year,
your total sum that will be charged on the market, the market equilibrium price of the machine as a total sale value,
will be $10,000 plus, not $10,000, but $10,000 discounted by, say, 10%, say $9,000,
and then the second year's $10,000 will be discounted by that plus another 10%, possibly $8,100, $7,300, etc.
In the next 20 years, the price won't be bid up to the $100,000 or $200,000 or whatever, it'll be that minus the rate of interest, so when you buy the house at the lower price, you'll have a room for the 10% return per year, or whatever the interest return happens to be.
This process, by the way, of summing up this kind of future returns into a present value is called capitalizing expected future returns into a present sum.
That's pretty obvious if we didn't have capitalization. Land, for example, wouldn't be able to be sold at all, because land is permanent.
Assuming the Fifth Avenue or 42nd Street will always be there, because it's a fixed part of the earth, sort of an atom bomb explosion, something will always be there.
So, we can expect that land is perpetual, or makes some sort of perpetual return. If we expect that land will bring you $10,000 return forever, let's say,
without an interest rate this kind, you'll never be able to sell it, because the price would be infinite. I can sell something at an infinite price.
Obviously the point then is that you sell land because the expectation of getting $10,000
all the year and C-1000AD doesn't loom very large in your consciousness, you're discounting
it by very heavily, it means almost nothing, you get down to a sort of asymptotic relationship
where it's virtually zero and this sum becomes the amount that you're willing to sell it
for and the amount the other guy is willing to buy it for.
So in equilibrium, the market price of the entire thing, whether it's a slave under slavery
or machine or a land or aggregations of these things will tend to be the discounted sum
of effective future rents or effective future returns.
The formula for a perpetual resource, the life of the thing is infinite such as land, is
a simple formula for this which sort of illustrates the capital value of C is equal to R, the
annual rent or the annual rate of return, divided by the rate of interest.
So if the annual return is $1,000 a year and the rate of interest is 10%, capital value
will be $10,000.
Now we see this happening all the time, by the way, in the stock market.
The point is that as returns increase, increased returns tend to increase the capital value
and vice versa.
The capital value of anything is proportionate to the annual return, expected annual return,
inversely proportionate to the rate of interest.
As the rate of interest goes up, it tends to lower the general capital value of everything.
And we'll see how this applies to conservation and why copper miners will produce a certain
amount now and wait for the next ten years to produce the rest of it, etc.
I think we have enough for this lecture.