Why Do Profits and Losses Matter?

Start Here: The Camera Kodak Didn’t Sell

In 1975, a young Kodak engineer named Steven Sasson built the first digital camera. “My prototype was big as a toaster, but the technical people loved it,” he recalled. “But it was filmless photography, so management’s reaction was, ‘that’s cute — but don’t tell anyone about it.’” Kodak’s business was film. In 1988 the company employed more than 145,000 people worldwide and earned a profit of $1.4 billion.

Over the next two decades, customers moved to digital cameras and then to phones, and the firms that served them earned the profits. Kodak did move into digital: by 2011 it said about three-quarters of its revenue came from digital businesses. Even so, in January 2012 it filed for bankruptcy reorganization. It came out in 2013 as what it called a “leaner” company focused on imaging for businesses.

WATCH Creative Destruction: Technology and Trade (Marginal Revolution University)

What Profit Is and What It Does

Earlier readings in this series covered the first two ideas below. This reading covers the last two.

To a business owner, profit is what is left of revenue after paying the bills. Economists count one more cost: the opportunity cost of the owner’s own time and money, an idea from the Choices reading. Accounting profit subtracts only the bills actually paid. Economic profit also subtracts what the owner gives up by not working or investing somewhere else. A shop can show an accounting profit and still lose money in the economic sense if its owner could earn more doing something else. When economic profit is zero, owners earn just enough to keep going. Economists call that a normal profit.

Read this way, profit and loss are signals about where scarce resources do the most good.

That is why high profits tend not to last. Unless something blocks new competitors, others copy what works and the extra profit shrinks. To keep earning more than a normal profit, a firm has to keep finding something new.

WATCH The Balance of Industries and Creative Destruction (Marginal Revolution University)

Four Ways to See Profit

1 Frank Knight: The reward for facing uncertainty

In 1921, Frank Knight drew a line between risk and uncertainty. Risk can be measured: insurers know roughly how many houses will burn each year, so they can price the risk and spread it. A measurable risk, Knight wrote, “is so far different from an unmeasurable one that it is not in effect an uncertainty at all.” True uncertainty can’t be measured. No one can buy insurance against launching a product no one has tried. For Knight, that is where profit comes from: “Profit arises out of the inherent, absolute unpredictability of things.” Someone has to make a judgment call and live with the result.

2 Israel Kirzner: The reward for noticing

As the Supply and Demand reading explained, Kirzner saw markets as never quite settled. Prices are always a little wrong because no one sees every change. Profit is the reward for noticing a gap others missed, such as something that sells cheaply in one place and is valued more in another. Acting on that gap earns a profit and, in doing so, closes it.

3 Joseph Schumpeter: The reward for creating something new

Schumpeter, writing in 1942, thought the most important profits come from big changes, not small ones: new products, new methods, new markets, new ways of organizing a business. He described a process that “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” He called it creative destruction. The digital camera is a textbook case: it created a new industry and destroyed much of an old one. Who gets most of the gains from such changes? Yale economist William Nordhaus, a Nobel laureate, estimated that from 1948 to 2001 innovators kept only about 2 percent of the value their innovations created. Most of the rest went to customers, through lower prices and better products.

4 Ludwig von Mises: Profit and loss as feedback

Mises stressed who is really in charge. In a 1951 paper he argued that business owners are “unconditionally and totally subject to the sovereignty of the buying public, the consumers.” Customers vote with their purchases: they “elect the entrepreneurs in a daily repeated plebiscite as it were.” Firms that fail to serve them “suffer losses and are finally eliminated.” In his view, “Profit and loss are the instruments by means of which the consumers pass the direction of production activities into the hands of those who are best fit to serve them.”

Why Losses Matter Too

Losses are the half of the story people forget. A loss is a message that the workers, materials, and money in a business would do more good somewhere else. Bankruptcy doesn’t make those resources disappear. When Kodak reorganized, it sold off patents it no longer needed, spun off whole businesses, and kept serving other customers. The people, buildings, and ideas it could no longer use well were freed for other uses.

What happens when losses carry no penalty? Hungarian economist János Kornai studied this in the planned economies of Eastern Europe and China. He found that when a firm expects its losses to be “paid by some other institution, typically by the State,” its budget becomes “soft.” Firms that expect to be rescued pay less attention to prices and to customers. Kornai found that this softness “weakens price responsiveness” and “leads to losses in efficiency.” He also saw it, to a lesser degree, in mixed economies like those of the West, wherever subsidies, tax breaks, or easy loans keep failing firms going.

Economist Deirdre McCloskey calls the bargain behind all this the Bourgeois Deal. Let ordinary people try their ideas, don’t resent the profits customers freely give them, and their innovations will make everyone better off. The deal has a second half that is easy to miss: the same customers who reward a new idea are free to walk away from an old one.

What Economics Adds

Key Terms in Plain Words

Accounting profit

Revenue minus the bills a business actually pays.

Economic profit

Revenue minus all costs, including the owner’s opportunity cost.

Normal profit

Zero economic profit: owners earn just enough to stay in business.

Economic loss

Revenue that falls short of all costs, a sign resources would do more elsewhere.

Entry and exit

Firms moving into profitable industries and out of losing ones.

Entrepreneur

Someone who makes judgment calls about what to produce and how, and bears the result.

Risk

Uncertainty that can be measured and insured against.

Uncertainty

Knight’s term for what can’t be measured or insured, and the source of profit.

Creative destruction

Schumpeter’s term for new products and methods replacing old ones.

Rent seeking

Spending resources to win favors from government instead of serving customers.

Soft budget constraint

Kornai’s term for a firm that expects its losses to be covered by others.

Bourgeois Deal

McCloskey’s bargain: let people innovate, don’t resent their rewards, and everyone gets richer.