Government isn’t the only problem

Working in a college, I’m at the front lines of a significant problem: wasteful bullshit jobs. In fact, I am writing this post to procrastinate editing a bureaucratic report (that nobody cares about) that has been slowly grinding the joy out of my life for the past several months. I have to write this report for the benefit of regulatory oversight which, ironically, is supposed to ensure that I use my privileged position for the benefit of society instead of wasting my efforts on pointless or destructive outlets.

In my case, this bullshit aspect of my job is a predictable outcome of working in a state sponsored bureaucracy. But the same disease afflicts private industry too.

If I’m the head of a Fortune 500 company, I have incentive to increase profitability of my company, but I have competing interests too. Most importantly I have to maintain my position of power within the company. Bruce Bueno de Mesquita and coauthors have laid out the logic of the situation in The Dictator’s Handbook, and The Logic of Political Survival–in a nutshell, I have to worry about competition for positions of power within any hierarchy. This requires engaging in cooperative rent-seeking to keep the right people happy. If I don’t, I risk losing my position to a sycophant who will.

We shouldn’t be surprised to see Niskanenian logic show up in these situations. Corporate flunkies are like a private army that can help me keep my position of power even if they don’t contribute to the profitability of the firm. Even if I want to maximize profits, if I have to worry about keeping my position, I have to engage in some of this costly, inefficient rent-seeking.

In other words, “firms maximize profit” is an approximation that brushes aside methodological individualism. Don’t get me wrong, there’s evolutionary pressure on firms that will push in that direction. But within a firm there’s evolutionary pressure preventing the firm from fully maximizing. (In other other words, if I survive this report I’ll have to start reading up on corporate governance.)

This logic is a natural source of bullshit jobs, even in a free market. Regulatory capture should make it worse, but we’ll never completely eliminate it.

On a more speculative note, I think we also have to worry about culture. For one, our current culture drives the demand for increased regulation. For another, we prize work for work’s sake to the point that most people would rather see someone fritter away their brief experience as a sentient being than see them fail to live up to social expectations. Such notions, I think, are behind the surprising lack of riots in the street you might expect in a world where most people know we face this problem of bullshit jobs. But I’ll leave any further speculation for the comments.

tl;dr: Our economy is beset with bullshit jobs that sap our creative capacity and crush our souls. And pretty much everyone knows it. Government is part of the problem, partly because regulation creates demand for paper-pushing, and partly because anti-competitive regulation converts lively, profit-seeking firms into private bureaucracies in their own right. But there are deeper problems: our willingness to abide, and the fundamental logic of hierarchical organizations.

The Concept of Profit

The basic concept of “profit” is simple: profit equals revenue minus costs. But “cost” is a complex concept, and “revenue” too is not all that simple, so the economic analysis of “profit” ends up being complicated.

A business typically calculates the appearance of profit rather than the economic reality. Most enterprises use money for purchases and sales, so for accounting, the appearance of profit is easy to understand. The revenue equals the proceeds from sales, and the costs are what is paid for the inputs: wages, rentals, interest, and materials. In economics, this is called “accounting profit,” which equals revenue minus the explicit costs, costs paid to others.

But the payments for inputs can include capital goods – inventory, buildings, machines and other tools – that last a long time. If an enterprise buys a machine that lasts for ten years, the cost is really spread out over the duration of the capital good. So in the accounting, rather than treat the purchase as a cost in the year purchased, the cost is the depreciation, the loss of value, in each year. For simplicity, the accounting can depreciate the tool in equal amounts each year, or, following tax laws, it could accelerate the depreciation, deducting more in the first years than the last years. The annual depreciation is an explicit cost, since the original purchase consists of funds paid to others.

This accounting convention ignores the effect of price inflation. Suppose a tool costs $100 and lasts for 20 years. Without inflation, the depreciation would be $5 per year. But if during that time, prices have doubled, it will cost $200 to replace the same tool. In the 20th year, the actual depreciation should be $10, but for the income tax in the USA, inflation is ignored, so the company has to record a $5 expense.

To get the real cost, we have to move from accounting profit, which only subtracts explicit nominal costs (not adjusted for inflation), to economic profit, which also subtracts the implicit costs, those which are not paid in money to others, but are nevertheless real.

The implicit costs include all the “opportunity costs,” the costs of giving up next-best opportunities. Suppose you are the sole owner of a business, and your accounting profit is $200,000 per year. Your next best opportunity would be to be employed at another firm for $80,000 per year. Since you give up a $80,000 wage by being self-employed, that is a cost of your business, and in effect you are paying yourself the $80,000 out of your accounting profit.

Suppose also that you own the real estate used by your firm. If you rented, the rental would be $60,000 per year. The opportunity cost of owing your business is the $60,000 you give up if you instead rented the place to a tenant. In effect, your business is paying you as property owner the $60,000 rent from your accounting profit.

Subtract $80,000 and $60,000 from your accounting profit, and your real gain is $60,000. That is the economic profit from your self-owned business.

The same concept applies to corporate profits. Suppose a corporation has an accounting profit of $10 million per year. It owns assets worth $100 million. If the assets were sold and converted into safe bonds, suppose the bonds would pay four percent interest, or $4 million annually. That foregone income is subtracted from the accounting profit, for an economic profit of $6 million. The firm obtains $4 million as an asset owner, and $6 million as an enterprise.

Another aspect of profit is honesty. If a thief steals $1000, this is not economic profit. True profit means that the gain came from voluntary enterprise and legitimately owned assets. Gains from force and fraud are not economic profit. From the viewpoint of the whole economy, profit also has to take into account costs imposed on others, such as from pollution. The absence of compensation for damages is really an implicit theft.

Accounting profit can include government subsidies. But since such subsidies are not from voluntary production, they are not included in economic profit, the real gain from production.

Profit can also consist of capital gains. If you buy shares of stock at $1000 and sell them later for $1500 (after paying the broker’s fee), the $500 capital gain is profit. If you instead had the $1000 in safe bonds and obtained $100 in interest, that would be the opportunity cost of the capital gain, so the economic profit from the asset is $400.

We can also look at opportunity cost from the point of view of society and the whole economy. The opportunity cost of government spending is what the taxpayers would have spent on. Land has an individual opportunity cost for the owner, but for the economy, land has no opportunity cost. The land is here by nature, and no more can be built or imported. Therefore, for the whole economy, all land rent is economic profit.

Economic profit has three origins. First there is entrepreneurial profit, the economic profit of an entrepreneur, due to his skills, insights, and talents. Second is monopoly profit, the economic profit that comes from a price greater than a competitive price, such as the profit from holding a patent. Third is the gains from asset appreciation.

Profit can be negative and zero. When an enterprise has costs greater than revenues, the loss constitutes negative profit. In a highly competitive industry, economic profits tend towards zero, as firms enter to gain profits and exit to avoid losses. But zero economic profit implies just enough accounting profit to pay for all costs, including normal returns on assets values.

If you want to be clear when talking about profits, you should not just say “profit” but indicate whether you mean accounting profit or economic profit. It gets a bit confusing, because when economists say “profit,” they mean economic profit, but when anyone else says “profit,” they mean accounting profit. It may be difficult to calculate economic profit, but we need to do it, because economic profit keeps it real.
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What Exactly is Profit, Anyway?

Co-editor Fred Foldvary explains over at FEE’s revamped website:

We also need to distinguish economic revenue from accounting revenue.  Suppose a thief enters a house and steals $1,000 of loot.  To break into that house he bought a tool for $100.  Ignoring the opportunity cost of his time, the thief’s accounting revenue is $1,000, and his cost is $100.  Is the $900 net gain a profit in the economic sense?

Stolen loot is not real profit because it is a forced transfer of goods or money from the victim to the thief.  True profit is a net gain from production and exchange.  If someone gives you a gift of $100, it too is just a transfer.

If instead of directly stealing wealth someone uses the government to forcibly take money from some and give it to others, the gain is also not true profit.

Read the rest here.