The Significance of Profit
Jul04
Money & Macro1

The Significance of Profit

A Failure of Equilibrium, or a Success of Coordination?

General equilibrium, we are told, is the benchmark for an economy – and in particular, a perfectly competitive general equilibrium. Departures from this standard are commonly called “market imperfections”. In such a state, no one can be made better off without making someone else worse off. In other words, all profit opportunities are already exploited; there are no profits left to make.

It is curious, then, that the times of highest general profit are regarded as good times economically. Does this not indicate we are further from equilibrium? Should a rise in corporate profits not be seen as a step away from pareto-optimality? And on the other hand, if recession were characterized primarily by disequilibrium, should we not expect profit opportunities to increase?

It may be argued that diminished profitability in recessions indicates, not the exhaustion of profit opportunities, but the inaccessibility of profit opportunities. At the very least, this suggests profit is a poor proxy for equilibrium. But more importantly, the very question of whether this state constitutes an equilibrium or a disequilibrium depends entirely on whether one considers these impediments as “given”. If we define equilibrium as the exhaustion of all accessible profit opportunities, then voila, recessions are more nearly a general equilibrium than booms. The fact that the distinction between equilibrium and disequilibrium depends more on the theorist’s perspective than on any economic facts makes the concept a dubious benchmark against which to judge actual economies.

Equilibrium is, of course, a useful analytical construct. Even if profit opportunities always appear faster than they are eliminated, it is significant that existing profit opportunities are systematically eliminated. But however illuminating the concept as a macroeconomic heuristic, it becomes nonsense when we try to use it as a benchmark for economic health – or worse, when we compare existing institutions against the theoretical conditions for a general equilibrium.

A more useful benchmark is coordination, the successful meshing of economic plans. Where equilibrium refers to the result of the economic process – one which never is and never could be actually attained – coordination refers to the process itself, which we observe every day. Where the failure of a market to clear has little bearing on the question of equilibrium, it is, by contrast, a clear indication of miscoordination.

No doubt many who invoke disequilibrium really mean something like miscoordination, or more specifically, that some market fails to clear. This is understandable given the convention of identifying the intersection of a supply and a demand curve as the “equilibrium”, but it is hardly an innocent metonymy. Given the fact that “equilibrium” has a particular theoretical meaning with specific implications (among which the lack of profit opportunities), it obfuscates the situation to bring in all that baggage when all that is meant is a much narrower failure of some market to clear. And again, by taking enough things as given, even this can be construed as an equilibrium (or close enough).

Thus in one sense coordination is very similar to equilibrium as a benchmark, but in another it is very nearly the opposite. Equilibrium implies the exhaustion and diminution of overall profit opportunities, whereas profitable exchange is very nearly the definition of coordination – certainly it is the goal of those doing the coordinating. The more profit, the more coordination, which matches our experience of good economic times. It is in this sense that Schumpeter calls entrepreneurship disequilibrating, even though coordinating on the whole. The most significant opportunities for profit are not merely found by entrepreneurs, but in an important sense are created by them.

One may, of course, note (correctly) that coordination is itself the exhaustion of profit opportunities that moves an economy toward equilibrium, and in this sense the two concepts are complementary. But as a benchmark for actual economies, as the question of profit demonstrates, an orientation toward the process itself is more useful than an orientation toward the theoretical and never-actually-attainable result of that process.

Coordination as a benchmark has the advantage not only of having relevance to actual economies, where knowledge and tastes are not simply “given”, but also of explaining cyclical profit opportunities better than departures from equilibrium. Economic “bad times”, then, would be ascribed to miscoordination rather than disequilibrium.1

More generally, unlike disequilibrium, the concept of miscoordination encompasses non-clearing markets, and includes other undesirable things that might not result in unemployment – in short, it says everything we might want a benchmark to say – without paradoxical implications about the prevalence and social desirability of profits.

Footnotes

  1. Richard Wagner makes an orthogonal point, writing,

    An economy can be represented by a network of human activity, some of which is engaged in executing original plans and some of which is engaged in rectifying plans that have judged to have been unsatisfactory. … An increase in the volume of miscoordination in a society will shift the pattern of activity in a society, but it need not alter the total volume of activity, and would represent a meaningful notion of waste instead…

    It is conceivable that miscoordination could increase without any impact on aggregate time series. Miscoordination induces revisions in plans. Labor is shifted from the execution of plans to the revision of plans. It is conceivable that this shift of labor can be accommodated within an unchanged aggregate volume of employment.

    To the extent that miscoordination is masked by aggregate employment time series, it will appear in profitability time series. For a given volume of employment, the necessity of revising plans entails diminished profitability. In such a situation the miscoordination is not so severe as to force the abandonment of those original plans (i.e. unemployment), but it does represent an additional financial constraint on those making plans.

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Joseph Schumpeter, Richard Wagner

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One Comment

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    Jim Caton

    Jul 15, 2014 at 10:45 | Reply

    There is no such thing as equilibrium or disequilibrium. They are useful concepts for prediction and analysis, no doubt. When we take them so seriously as to characterize deviations from hypothesized equilibrium as market imperfections, we’ve begun to take the GE model too seriously. The proposition of a platonic form – perfect competition – is made to much of when we think of the form as a goal rather than a form of analysis.

    I should also add that if, within the model, we do observe disequilibrium, we have to ask why markets are not clearing. The impediment might be insurmountable. Often, though, it is due to inane policy.

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