Tuesday, February 02, 2010

Profits Are Good

A lot of people seem to find Goldman's profits rather disturbing--these guys are in it for themselves! That can't be good! Ah, but Economics was created as a separate discipline based on the insight that the unintended consequences of self interest are, often, quite good. As even today most people find this incredibly difficult to believe, I figure I would point to some seminal references on this. After all, profits are not bad, losses are, and it's good to remember that.

The magic of the free market is based fundamentally on the assumption that people are self interested, and so profits are sought after, and losses shunned. Given sufficient freedom of entry and property rights, firms will compete for those profits and in the process generate greater consumer surplus for your average schlub. Today's doofus lives a pretty good life relative to his counterpart in the middle ages, through neither his doofus antecedents or the conscious intentions of his actual benefactors

This is the invisible hand that magically transforms the greed of individuals into a social good totally orthogonal to their explicit intention. That it is a truly remarkable insight is reflected by how counterintuitive it is to this day. I think the underlying reason most intellectuals do not trust the free market is because they feel that left to itself, the market tends to monopoly, inefficient outcomes as highlighted in RollerBall, or It's a Wonderful Life. Global Warming and health care policy concerns are both, in a sense, driven by the intuition that without top-down guidance, we are like airplane passengers without a pilot, doomed to catastrophe.

But, markets do force profits to zero, as anyone in business can attest. Not immediately, but over only a few years. The best descriptions of the competitive process and how it is consistent with efficiency, for me starts with Risk, Uncertainty, and Profit, in which Frank Knight describes how people respond to profit opportunities, and how this both lowers profits and provides lower costs to consumers. Friederich Hayek's most important essay, The Use of Knowledge in Society, noted the way the price system aggregates information in a way a Politburo could not, and I quote it at length only because what he says here is what virtually every free-marketer tries to say all the time (to little avail):

... or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.
To gain an advantage from better knowledge of facilities of communication or transport is sometimes regarded as almost dishonest, although it is quite as important that society make use of the best opportunities in this respect as in using the latest scientific discoveries. This prejudice has in a considerable measure affected the attitude toward commerce in general compared with that toward production. Even economists who regard themselves as definitely immune to the crude materialist fallacies of the past constantly commit the same mistake where activities directed toward the acquisition of such practical knowledge are concerned—apparently because in their scheme of things all such knowledge is supposed to be "given."
Of course, these adjustments are probably never "perfect" in the sense in which the economist conceives of them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or "normal" level.


those who clamor for "conscious direction"—and who cannot believe that anything which has evolved without design should solve problems which we should not be able to solve consciously—should remember this: The problem is precisely how to extend the span of out utilization of resources beyond the span of the control of any one mind; and therefore, how to dispense with the need of conscious control, and how to provide inducements which will make the individuals do the desirable things with

Sandy Grossman won the John Bates Clarke medal in 1988 based on more mathematical demonstrations of this view, how a profit seeking agent gets information into prices, and how this increases welfare.

This is one of those things that, if you believe it is important and generally true, is why you tend to favor market solutions; if you think it's for parochial cases of perfect competition, why you tend to favor top-down solutions. I obviously can't 'prove' why I think it is a better rule of thumb than any alternative, in that there are cases where it is untrue (monopoly, cartels, irrational businessmen). Futher, you can show that if certain increasing returns to scale (eg, Krugman's Nobel insight) are present, or informational asymmetries present (Stigltiz's Nobel insight), a modeler--who knows everything, isn't petty--can improve the equilibrium. I tend to find these exceptions as that, exceptions to a general rule.

More importantly, the solutions to imperfections are not a high-minded as modelers let on, in that while one can prove a situation is inefficient when you have a small set of assumptions, and then, God-like, note that you could make these imaginary people better. Yet one must consider that the bureaucrat in charge of fixing things is just as irrational and self-interested as any businessman or consumer. That is, if you think profits are a poor shepard, what about elections? With majority rule, there is a pressing desire to pass a law taking the money from the top (indirectly, usually). Given wealth and power always has a power-law distribution (fewer on the top than bottom), there will always be a desire by the masses to turn things upside-down. Thus, you have anarchy or coalitions waxing and waning like in the Roman Empire.

Our current climate seems to be that popular politicians are like union bosses or Marxist dictators, chiefs who state they are implementing the People's Will, all the while effecting more power than any CEO. This populist approach can only work within well-defined coalitions, because it necessarily involves Lenin's famous 'Who? Whom?' question (ie, who would prevail over whom?). You can't get power without taking someone down, you can't get patronage jobs without restrictions on entry. There really isn't a powerful coalition for maximizing GDP, because it doesn't exclude and include based on who signs up.


Anonymous said...

On one hand, human beings are sentient creatures with free will who live in a complex uncertain world and are guided by ideologies and belief systems.

On the other hand, they also live in a deterministic universe, bound by "laws" -- most obviously physical laws but also economic laws.

On one hand, politics and beliefs must matter (I assume that's why you bother to commnicate your ideas on your blog, not because there's some material gain from it). On the other hand, politics and beliefs are only delusions that either have no effect on the world, or can only have a deleterious effect on the world, by slowing down the efficient mechanics of the natural social order.

This kind of reminds me of Robin Hanson writing about how everything in life boils down to status games, and people responding by saying "How true" instead of "How status-enhancing." The worldview provides insight but is not truly as all-encompassing as it pretends to be; it piggybacks on intuitive notions like "Scholars seek to discover and explain the truth" even as it supposedly undercuts and eliminates them.

Same for "A relatively small number of people have a disproportionate impact on our institutions."

Anonymous said...

I don't personally know anyone (left or right) who views profit per se as bad. I know many who view profiting through looting the treasury and receiving special regulatory favors as highly offensive.

zby said...

Two cents from an observer of recent developments: while I more or less agree with you - it seems to me that trading in risk can be another exception to that optimising market theory. It just seems too easy to take on risks overwhelming the capacity to repay them.

Anonymous said...

I thought people were mad at Goldman Sachs because they had a hand in creating this crisis, had their former boss decide to close their biggest competitor while everyone else got bailed out, are essentially getting a government subsidy (like the rest of the banking system) with incredibly low rates ... but are still dipping their balls in gold.

killben said...

But there is no free-market!!

At some time there will be intervention in the guise of overall good ... THIS IS THE BIGGEST PROBLEM OF MARKET-ORIENTED ECONOMIES

So you get an "Privatise Profits, Socialise Losses" economy!

A free-market can function when there is no intervention, whatever guise it takes!!

If true market-oriented economy had been practised you will not be talking about BOA, Citi, GS, JPmorgan .. all gone to the bin to where they belong .. instead you have the Times "MAN OF THE YEAR" creating "THE MORAL HAZARD" all in the guise of greater good. Who is to define what is greater good.

I would say allo the cookie to crumble, people who are capable will get up, dust themselves and get on with it .. This is the true market-oriented economy in action ..


Anonymous said...

Profits are good, when they are earned through efficiency or whatever, and not when they are earned through monopoly, back door subsidies, and the capture of the regulators.
Off with their heads.