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Where do profits come from?

The Sultan of Brunei is the one of the very richest men in the world. The vast amount of land, technology and other property that he owns yields a huge profit. But where do his profits and the wealth of others like him come from?

Where do profits come from?

So, profits play a key role in the operation of the market system (Why Profit Gets Priority) but where do they come from? What is their source? For a business, profits are the difference between its total sales, revenue and its total costs of production.

The costs of production are:

  • the cost of the raw materials—components, power and services used up in the course of producing the goods being sold by the business;
  • the wear and tear of the fixed assets of the business, or the depreciation of its buildings, machines and other equipment;
  • the wages and salaries of the workers employed to do all the work involved in transforming the raw materials, etc. into the goods for sale.

Any income over and above these costs is profit.

It is out of this profit that the business pays any rent, interest on borrowed capital, dividends to shareholders, any national and local taxes. Anything left after that (retained profits) is available for investment in improving and expanding the business's productive capacity.

As we saw in Economists—Not On This Planet the only way in which wealth can be produced is by humans working with and on materials that originally came from nature. So profits, as a share in the product, can only come from labour.

Karl Marx (1811–1883) took up this point and made it the basis of his theory of "surplus value" this being the value added to the raw materials in the course of production by the workforce over and above what they were paid as wages.

Needless to say, this theory of profits as surplus value is anathema to orthodox economics and you won't find it expounded in any standard textbook. Instead you will find profits defined as being the "rewards" either of capital or of "entrepreneurships" (they can't agree on which). But, as the word "reward" indicates, these are convenient justifications for those who receive them . Unfortunately for these ideologically-minded economists, their moralistic justifications of profits are undermined by the facts.

What The Statisticians Reveal

As we also saw in Economists—Not On This Planet, the value of the new wealth produced in a country over a given period (its national product) will be the same as the incomes of all its inhabitants (its national income). It is the task of the National Income statisticians to work out ways of measuring these.

The key concept used by National Income statisticians is that of value added. In calculating a country's national product it won't do to simply add up the monetary value of the output of each industry since this would involve double, triple and even higher multiple counting. This is because the output of some industries is not sold to the final consumer but to another industry to serve as the material for its productive process.

To avoid this problem of multiple counting, goods used as the inputs of other industries have to be taken out of the calculation. It is this that the concept of value added is designed to do. Value added is defined as the difference between the total income of a business and the cost of its bought-in raw materials, components, power and services and of the wear and tear of its fixed assets. It is a measure of the economic value added to these inputs in the course of their transformation into the output the business sells. It differs from profits in one respect only: it includes wages and salaries.

So Profit = Value Added—Wages and Salaries.

Profit, in other words, is a deduction from the value added by labour in the process of transforming inputs into outputs.

This is true at the level of the economy as well as at the level of the individual business or branch of industry.

To get a figure for the national product, the value added in each industry (itself the addition of the value added in all of its constituent firms) is totalled up. But since value added is composed of wages and salaries plus profits an alternative way is to add the total profits made by all businesses to the total of the wages and salaries paid to all workers. This of course is the national income, which is just another way of expressing the monetary value of the national product, or total new value added to previously existing value in the course of a given period.

This equivalence between national product and national income brings out the fact that all monetary incomes arise out of the process of production. All income is initially generated in production as either profits or wages and salaries. All other incomes—rent, interest, pensions and other benefits paid by the State—are ultimately derived from these, mainly from profits in fact.

Profits, then, are not only the source of funds for investment in improving and expanding productive capacity, they are also the source of nearly all government expenditure. The profit-making sector of the economy (whether private or state-owned), therefore, really can be said to be, as its defenders often claim, the "wealth-creating sector" of the economy: it is the sector that provides the surplus for both investment and government expenditure (The Taxation Myth). (However, since profits themselves are derived from the value added by labour in the process of production, it is labour that is the ultimate source.)

What Is Economic Growth?

Government statisticians provide regular statistics on the size of the national product but these are not always the same. Sometimes figures are quoted for Gross Domestic Product (GDP), sometimes for Gross National Product (GNP), and sometimes for NNP. What do these initials signify and what is the difference between them?

GDP stands for Gross Domestic Product. Figures for it are produced on a quarterly basis. The significance of the word "gross" is that it indicates that the figure covers not just value added but also the depreciation of fixed capital. Strictly speaking, as we saw, this should be excluded. The only reason it isn't is that meaningful figures for it cannot be produced on a three-monthly basis. GDP, then, is larger than total value added.

GNP stands for Gross National Product. It differs from GDP in that it takes into account transactions with other countries: exports and imports and payments to and from abroad. Payments from abroad for exports, services ("invisible exports") and from investments abroad increase the national income while payments to people abroad decrease it. As its name of Gross Domestic Product implies, GDP is a raw figure for value added (depreciation without taking into account transactions with other countries.) This is because the output of some industries is not sold to the final consumer but to another industry to serve as the material for its productive process.

To avoid this problem of multiple counting, goods used as the inputs of other industries have to be taken out of the calculation. It is this that the concept of value added is designed to do. Value added is defined as the difference between the total income of a business and the cost of its bought-in raw materials and components.

One of the long-run tendencies of the market system is an increase in NNP/National Income, or 'growth'. Actually, this is a consequence of another, more fundamental tendency but which is not quoted so often as it is now so easy to measure: the increase in the amount of capital invested in production, or 'capital' accumulation.

We saw earlier how the pressures of competition force businesses to seek to maximise their profits (Why Profit Gets Priority) as a way of maximising the amount of money they can devote to purchasing the new, more productive machinery and methods of production they must have to be able to produce more cheaply. This increase in the amount of money invested in production, or capital accumulation, translates in physical terms as an increase in the stock of means of production, both buildings, machinery and other fixed equipment and raw materials to be transformed into new goods. This in turn leads to an increase in national product/national income -growth.

Accumulation, in short, is the increase in productive capacity that makes possible the increase in output that is growth.

Investment, Consumption and Government Spending.

Capital accumulation depends on investment, or the proportion of national income that is used to purchase new means of production. So in this context it is the division of the national income into 'investment' and 'consumption' that is important. Some economic thinkers have argued that because investment is a deduction from consumption it must reduce the market for goods. This view is clearly wrong. Money that is invested is still spent, only it is spent on purchasing means of production rather than consumer goods. The distinction between investment and consumption is a difference between the purpose for which the national income is spent.

Where does government spending fit into this? Here unfortunately the National Income statisticians go off the rails. There is no problem with public corporations (they are just as much part of the market sector of the economy as any private company) and the activities of their workers create value-added that counts downwards the national product. But what about the government's current spending, as opposed to its spending on buildings and equipment, for such things as administration, the police and armed forces, education and health care? This is clearly consumption and not production, as an earlier generation of economists recognised. The government is consuming wealth in the same way that individuals do.

This is not how the National Income statisticians see it. They regard the government as somehow being engaged in producing 'public goods', called 'education' and 'health care' but also 'administration' and even 'defence' and 'law and order', which does create value added that can be added to the national product. Even on their own terms, however, there is something peculiar about this since the value added in the so-called public goods sector is equal only to the wages and salaries paid to those employed in it, there is no element of profit. So this means that the National Income statisticians are simply adding to the national product the wages and salaries of government employees. It is significant that they are not prepared to go the whole hog here and classify this as 'investment,' as the logic of their argument implies.

This in itself ought to be a clue that government current spending on administration and the rest is different from businesses spending on producing their goods for sale. The whole fiction that governments are producers engaged in producing public goods collapsed when the question is asked: where does the government get the money to pay the wages and salaries of its employees from? From the sale of goods as do other producers? Not at all, since the goods in question are now sold. They get it by taxing incomes generated in the market sector of the economy or by borrowing from those in receipt of such incomes.

In other words, the wages and salaries of government employees are 'transfer payments' as incomes transferred from one section of the population to another are called, pensions and other social security payments, for instance, and interest on the national debt. At one time interest payments to holders of the national debt were included in the national income statistics as part of the income derived from property ownership but this was dropped when it was realised that this was just a transfer via taxation of property income from one group to another. Logically, the same thing should be recognised for the wages and salaries of government employees. They too should be seen as 'transfer payments'.

Rejecting the concept that government employees produce public goods is not to reject recording in the national product/national income statistics expenditure on education, health care and defence. The argument is about how and where this should be classified. The mistake of classifying government spending on the wages and salaries of its employees as production has two consequences. First, it artificially inflates the size of the national product (and also the share of income from employment in it). Second, it sustains the illusion that in a slump the government can increase the national product simply by borrowing money from the market sector and spending it on, literally, anything.