Thursday, December 15, 2011

Where do Profits come from?

This week's EconTalk Podcast: Munger on Profits, Entrepreneurship, and Storytelling

In this week's EconTalk Munger and Robers presented and discussed several mini-stories about trading. They explored many angles of society's common, mistaken malignment of trade. Specifically, the malignment of profit acquired solely through trade without actually "producing anything". The entire 'cast is excellent and well worth your time listening to or reading the transcript (also available at the link above).

I want to point out two statements from the pod-cast that were particularly awesome.

"The source of profits is correcting errors."

The whole quote is:
The source of profits is correcting errors. The economy around us is full of errors. And what I mean by errors is a maladjustment, a divergence between what we are actually producing and what we "should" produce in order to use the stuff that we have--our mental resources, physical capital, labor--to produce the highest possible level of satisfaction of what the public wants. -Munger 

If you chew on that for a bit you'll find it is an astonishingly deep insight. In economics there is a concept of optimality where supply has been balanced to exactly meet demand and price has been adjusted to exactly match costs. In other words, an optimal market has no profits. What we have, instead, in the real world, is a sub-optimal market. Resources have not been balanced optimally. There are gaps in the market where goods and services are not being put to their optimal use. If someone can discover these, they can connect the good or service with a more optimal use, benefitting both the producer and the consumer, and gaining some profit. All three parties benefit from the trader correcting an error in the market.

Now for the second awesome statement. First I'll paraphrase:

Trading as a more equitable means of maximizing 
individual satisfaction than 'goodwill'.

The second statement is from the last story Munger and Roberts discuss. It appears to be a true story about a British officer name R.A. Radford who had a background in economics and became a POW during WWII. His POW camp of 2400 inmates lived solely on rations provided by the red cross. The rations were identical for every inmate and identical month to month. From an economics point of view, the production of the entire closed society was static and egalitarian. This clearly sets up a fascinating case-study for how a society might organize when production is not an issue. Radford wrote up his economic observations later in an essay which is available online: The Economic Organisation of a P.O.W. Camp - R.A. Radford.

The whole quote, directly from Radford's essay is:
Very soon after capture people realized that it was both undesirable and unnecessary, in view of the limited size and the equality of supplies, to give away or to accept gifts of cigarettes or food. "Goodwill" developed into trading as a more equitable means of maximizing individual satisfaction. -Radford

What a wonderful statement! Wonderful, I suppose, if you are already pro-free-markets. If you think about it, though, it makes sense. If I give you the bits of my rations I don't want I may benefit you some, but I don't know if you are the person in camp who would benefit most from my gift. How should I answer that question? I need some way of finding out the value of my extra rations to every person in the camp. The problem is there are 2400 people in the camp, and they each have some bit of extra rations they too aren't using and would like to find the most valuable use for. How do you solve such a complicated problem, and do you really need the cooperative 'goodwill' of all 2400 people?

No, you just need trade.

Trade and, by implication, a price system are the best known way of solving such a complicated constraint optimization problem. Every single trade benefits both parties, generating wealth for both. If it were not so, they wouldn't trade. If there are inefficiencies in the trades, if the overal economy is sub-optimal, if there are errors in the system, then traders can arise to correct those errors and bring the overall system closer to optimality profiting themselves, yes, but also the people they trade with, and via proof-by-mathematical-induction, everyone in the camp.

Fascinating! This simple podcast which was pretty light as EconTalk goes really got me thinking.

NOTE: All the above assumes the trades are without fraud or coercion. This appears to have been mostly true in the POW example, though if you read the essay, various interesting market failures did occur, and were, for the most part, corrected by market forces. Roberts and Munger to address this in their discussion as well.