“There’s a cream shortage in Victoria,” we overheard the dairy salesman telling Adam, the man we buy our coffee from each morning.
“Have the cows gone on strike?” we asked the salesman.
“No.” We tried another tack.
“Are you paying more for cream too, at the wholesale level?”
“No, not yet. And we haven’t raised prices. We probably could. But what’s the point really? We’d just end up upsetting our customers for the sake of a couple of dollars right now.”
“You mean it’s better to have a happy long-term customer than take advantage of the current cream shortage to make some profits.”
“You bet mate.”
This reminded us of the note we published yesterday about capitalism and greed. Many critics of capitalism point to the worst crooks the system produces as examples of the inherent unfairness or greed of being in business for a profit. This is moronic, or perhaps just a terrible misunderstanding.
If you’re not interested in a discussion of why profits are natural, healthy, and indispensable to a functioning market, that will conclude today’s notes from the Old Hat Factory. If you are interested, read on.
You don’t judge an economic system by its worst offenders. You judge it by how much prosperity it creates for the largest number of people. And to make a sound judgment, it doesn’t hurt to have a basic understanding of how the system consistently produces better outcomes for more people.
Your average capitalist—and we are talking about the small businessmen and women, innovators, and entrepreneurs that run most of the country’s businesses and create the most new jobs—applies his skill, knowledge and labour to create something other people find valuable. The application of his efforts creates value where none existed before.
The reward for his efforts is a profit. But the profit is a double edged sword. In addition to being a reward for value-added, profit is a signal to other potential producers: do this thing better or sell it for cheaper and there’s profit in it for you too. This is why the best place to open a new restaurant is generally right next door to a restaurant that’s already successful.
This is why profits are crucial to a free market. They signal to producers what consumers are willing to pay for. The signal attracts more producers, which lowers prices and improves quality for consumers. Without profits, then, consumers would have fewer choices, pay higher prices, and receive poorer quality goods and services.
Profits stay abnormally high in markets where a producer enjoys a virtual monopoly (Telstra) or where the government creates barriers to entry on behalf of favoured producers (Qantas). Any time profits are kept abnormally high, consumers suffer. But it’s not profits that are problem, it’s the lack of competition.
Incidentally, this is why investors are often willing to pay a premium for growth stocks. A new company in a new industry often rakes up higher profits in the early years, before the competition emerges and the entire industry matures. This is the fundamental basis for investing in small capitalisation stocks…you want to capture the abnormally large profits of early-stage innovators and first-to-market companies.
Anyone who’s ever owned or run a small business understands that greed can never be the basis for a successful enterprise. Your shortest rout to business success is not through price gouging. You simply have to provide people something they want at a price they’re willing to pay. You do that by practicing sound business ethics—like not charging your core customers more for cream simply because you can. Bad ethics is bad business.
That seems deceptively simple. In fact, it’s so simple that most people miss it. And we realise there are exceptions. But providing real value to your customer is the hidden principle of trade and commerce.
There’s another principle that doesn’t involve greed at all. It involves the efficient allocation of scarce resources. To trade anything successfully, you have to produce a finished good that’s more valuable than the raw materials and labour you’ve put into it. There are two basic ways to do this.
First, you can move an item from the place where it’s less valuable to a place where it’s more valuable, from a place where it’s abundant to a place where it’s scarce, from the place you found it to the place where it’s not found at all.
Take the iron ore of the Pilbara. There’s plenty of it laying around in the Pilbara. But the Pilbara is not in China. The ore is valuable in China because China needs steel. The Australian companies that trade in iron ore simply move it from where it’s abundant to where it’s scarce. For their observation and their troubles they are entitled to a profit—having identified a resource people want and a way to get it to them.
The other way to trade successfully is to add value to group of raw materials by putting them together in a novel and useful way. It could be fallow farmland you turn into corn or wheat, or opening a deli on a corner near an office building full of hungry workers, or importing Buddhist prayer flags made in China for the inner peace of white collar workers in Melbourne. No matter what he does (except, perhaps, in financial services), the entrepreneur must be the servant of the customer if he’s going to make a profit.
The division of labour makes for tremendous variety in the goods and services you can buy. What you buy is up to you. But we should not be ungrateful for the huge variety of choice we have, of the system that produces that variety. Unless you view choice as a burden, what’s the complaint? Our only real complaint is that the sheer abundance of choice has turned many people into consumers rather than producers, and thus the net wealth of the culture is in decline.
But there is nothing wrong—practically or ethically—with the working principles of capitalism. A good entrepreneur will look at any group of raw materials and produce a whole that is greater than the sum of the parts. Whether he applies his labour or his brain, he’s providing the same service to the economy…producing a good or service where none existed before.
The desire for some reward for his labour is natural and healthy. It’s not greed. Without the incentive for profit, the variety of goods produced would decline. This—among many other reasons related to the flaws of a command economy—is why the shelves of grocery stores in Soviet Russia were bare.
We won’t belabour the point. And of course there is fraud and injustice in the free market. But you do not eliminate fraud by eliminating profits. Feel free to add your two cents by posting a comment below.
The Daily Reckoning Australia