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An introduction to Marxian economics 2: the rate of profit

What is the rate of profit?

The rate of profit measures the return on invested capital over a given period and is usually expressed as a percentage. So, if a capital investment of £ 100,000 turns over in a year and the profit is £20,000 then the rate of profit is 20,000/100,000 or 20 per cent per annum.

If a capitalist was starting from scratch he would have to use some of his original £100,000 to buy a factory building and to equip it with machines. He would then have to buy raw materials and pay for electricity to power the machines. Finally he would have to use some of his capital to hire workers and pay their wages. Let us assume that the factory, the machines, the raw materials and the electricity cost him £80,000 and that his wages bill comes to £20,000.

The organic composition of capital

Marx isolated the capital invested in hiring the workers because, the only source of new value being the exercise of labour power, this was the part of the capital which increased to provide free for the capitalist a profit, or surplus value, of in this case £20,000. Marx called this part the variable capital (v). The other part invested in the factory, machines, etc. was just as essential to production but its value was only transferred to the final product without any change in its size. Which was why Marx called it constant capital (cc). There are various relations between total capital (C) and its components:

  • s/C or s(cc + v) is the rate of profit

  • s/v is the rate of surplus value

  • cc/v is the organic composition of capital

The organic composition of capital expresses in value terms the technical relationship between the productive apparatus and the number of workers needed to operate it, what academic economists would call the degree of capital intensity.

The falling rate of profit

We will assume that in the second year our capitalist re-invests all of his £20,000 profit. If there has been no technical progress he would divide it as previously, using £16,000 as new constant capital and £4,000 as new variable capital. Assuming that the rate of surplus value is unchanged at 100 per cent, his profit will be £24,000 in that year and the rate of profit 24,000/120,000, still 20 per cent.

But assume that there had been technical progress and that he only needed to use £1,000 as new variable capital and so could use £19,000 as new constant capital (this is only an example; we are assuming here an unrealistically fast rate of technical progress). The organic composition of the total capital would rise but, with the rate of surplus value remaining the same, the rate of profit would fall to 21,000/120,000 or 17½ per cent.

So, insofar as technical progress raises the organic composition of capital it reduces the rate of profit. As labour power is the only source of surplus value and as the amount of surplus value depends on the amount of variable capital, if the share of v in total capital falls (and if s/v remains constant) then the rate of profit must fall. This spectre of the rate of profit falling as the stock of constant capital grew worried the classical economists Adam Smith and Ricardo and their successors like John Stuart Mill. They foresaw that, if this went on, the profit-motivated capitalist system would soon reach a state of chronic stagnation.

Why so slow?

Marx approached the problem from a different angle. He wanted to know why the fall in the rate of profit had in practice been so slow. There must be, he deduced, some counteracting influences and, using the labour theory of value, was able in Chapter XIV of Volume III of Capital to work out what these influences must be. Now, what does technical progress mean besides a growing capital intensity? Surely an increase in productivity as machines replace human muscle power. Applied to the machine-making industry this would mean that more machines could be produced in a given time so that the value of each of them would fall. This effect Marx called "cheapening the elements of constant capital". Academic economics calls it "capital saving".

Increasing productivity in the industries making goods consumed by the workers has a similar effect on variable capital. It will in fact increase the amount of surplus value by shortening the time during which the worker reproduces the value of his own labour power, which is the only part of the working day the capitalist has to pay for (this does not necessarily mean a decline in the workers standards of living, as explained in the article "Relative Wages"). The rate of surplus value can also be raised by increasing the intensity of work, by lengthening the working day and even by depressing wages below their value. Competition for jobs will also keep wages down and so limit how much the capitalist has to invest as variable capital.

This-the cheapening of the elements of constant capital and the rise in the rate of surplus value-was Marx's explanation as to why the rate of profit only tended to fall slowly. He accepted the classical economists' view that the rate was falling but expected this to be a slow, long-run tendency. He did not believe that the rate of profit was always falling since at times the counter-tendencies could be the stronger.

The rate of profit can also be raised by reducing the period in which the capital (or part of it) is turned over. In our example the £ 100,000 turned over in a year; if this was reduced to six months the amount of profit would become £40,000 and the rate of profit 40 per cent per year. The development of commercial and financial institutions independent of industrial enterprises-and the introduction of shift-working and other forms of "rationalisation"-tends to shorten the turnover period and so to raise the annual rate of profit.

How the rate of profit moves even in the long run cannot be predicted from pure theory. This movement depends on which of the influences at work proves to be the stronger at any particular time or over any particular period, a fact that can only be discovered by empirical research. Some attempts have been made to estimate what has happened in the past hundred years but the results are conflicting. It has been suggested that the organic composition of capital stopped rising about 1920 due to "capital-saving" inventions.

Because Marx's theory of the tendency of the rate of profit to fall is meant to describe a slow process which would only become evident in the long run it cannot be used to explain periodic crises. The onset of a crisis is, however, often linked with a fall in the rate of profit as wages rise in a boom—but a fall caused by a short term fall in the rate of surplus value rather than by long term changes in the organic compositions of capital.

It is true that Marx does (Chapter XV) discuss crises in connection with the falling rate of profit, but with a view to explaining their significance as a counteracting tendency. For, during a depression, the value of the constant capital depreciates considerably while some of its elements (machinery, stocks) are often physically destroyed. To say that crises help offset the long-term tendency of the rate of profit to fall is quite different from saying (as John Strachey does in his The Nature of Capitalist Crisis) that crises are caused by it.