The Price System, Part 2: Profits & Losses

Release Date
June 29, 2011

Topic

Basic Economics
Description

What is the social function of profits and losses? As Prof. Daniel J. Smith of Troy University describes, they provide an incentive for people to follow the information provided by the price system. By pursuing profits and avoiding losses, producers and consumers use scarce resources in effective ways. In anticipation of being rewarded with profit, people and businesses are encouraged to undertake activity that will create valuable outputs. At the same time, the potential for losses encourages them to avoid excessive risks and wasteful activity. Policies that reduce profits, such as taxation, or reduce losses, such as bailouts, disrupt this function of prices and lead to inefficient uses of resources.

The Price System, Part 2: Profits & Losses
Prices generate, aggregate, and transmit dispersed knowledge to producers and consumers. But what good does this knowledge do unless producers and consumers have the incentive to respond to that information by incorporating it into their plans and actions? This is why both profits and losses are crucial.
The pursuit of profits and the avoidance of losses provides firms and individuals with the incentive to respond to the flow of information provided by prices. Profits and losses inform producers if they’re using scarce resources to create products that people want at prices they’re willing to pay. They are a feedback mechanism providing the incentives for people to respond to the information being provided via the price system. Profits foster the pursuit of new opportunities. They encourage people to undertake the risk necessary to come up with new products and new ideas. Every new idea and new business is a risky undertaking, and humankind would still be stuck in the Stone Age if we did not have the incentives provided by profits. Profit seeking is simply an attempt to create the goods and services that we value with as few resources as possible. This frees up resources and labor to be used in producing other goods and services that we value.
Losses, by contrast, encourage prudence. They counter the incentive for profit seeking and discourage excessive risk taking. If a business sustains enough losses, they will eventually go into bankruptcy. This plays an important economic function. It cleans out businesses that make poor economic decisions. Bankruptcy also frees up those resources to be reallocated towards producing goods and services that create more value for consumers.
If a railroad company used gold for their rails, they would be led, through market prices, to switch to less expensive metal, such as steel. If they didn’t switch, they would sustain substantial losses and go out of business. Keep in mind that bankruptcy is not a failure of the market. It is the market working. When a corrupt or incompetent politician is voted out of office, it is the electoral process operating. It is the same concept when an incompetent business goes bankrupt.
When that happens, those companies’ resources are reallocated to be used by more successful businesses. If you attempt to mitigate the effects of bankruptcy, you severely diminish the incentive for prudence and encourage excessive risk taking. This is what economists call moral hazard. A good example of this is government sponsored enterprises, such as Fannie Mae and Freddie Mac. These organizations took on especially risky portfolios due to the fact they had an implicit guarantee to be bailed out. This creates perverse incentives, where bankers reap all the gains but suffer no losses for high-risk investments. Together profits and losses play an indispensible role in the economy, orchestrated through prices. They ensure that scarce resources are continually reallocated to maximize value for consumers.
Attempts to curb profits through progressive taxation or to mitigate losses through subsidization or too big to fail policy significantly impairs this important function of prices. This leads away from the optimal use of resources in the economy, making consumers worse off.