What’s the profit motive and how is it supposed to work?

Every so often, I’m going to post a short explanation of concepts that are particularly useful for thinking about sustainability, social structure, economics or other themes relevant to The Progress Motive.  First up, it’s the profit motive, which is key to understanding how the current economic system is supposed to work.

What’s the profit motive?

The profit motive is the desire to make money.  In a free market (where people voluntarily swap money, goods and services), the profit motive decides who gets what.  In theory, the profit motive distributes resources efficiently, but in practice there are some problems.

How is the profit motive supposed to work?

Profit is the reward for doing something useful

A business can make a profit by selling a product or service at a market price that is higher than the cost of production.

Market price is determined supply (how much of a particular item is available for sale) and demand (how much of that item can be sold).  Both supply and demand vary with price.  Supply tends to go up as price goes up, because more profit can be made at a higher price, encouraging businesses to sell that item.  Demand tends to go down as price goes up, because not everyone can afford more expensive items and because people might decide to spend their money on something else.  The market price is the price at which supply equals demand, meaning that everyone who is willing and able to buy that product at that price can do so, and none are left unsold.

The market price shows how valuable a product is to customers and tells businesses whether to bother making it.

Let’s say that it costs a juice business £1 to buy apples and £1 to juice and bottle them, making a total cost of production of £2 per bottle.

If people will only pay £0.50 per bottle of apple juice, then the business makes a loss of £1.50 per bottle.  It wastes resources by turning relatively valuable apples (£1) and effort (£1) into relatively worthless juice (£0.50).

If, however, people are willing to pay £3 per bottle of apple juice instead of buying and juicing the apples themselves, then the business helps its customers.  It adds value to the raw materials and makes a profit of £1 per bottle in return.  Crucially, the business does something useful not out of kindness, but because it wants to make money.

The profit motive corrects undersupply and oversupply of goods

The beauty of the profit motive is that, in a free market, it automatically corrects shortages and surpluses of different products by balancing supply and demand.

If lots of people want potatoes, for example, but the harvest was low this year, then the price will be high.  The few potatoes that are available will be sold to the small number of buyers who are willing and able to pay a lot for them.  The high price encourages farmers to plant more potatoes, which increases supply and brings the price down.

On the other hand, if there is a glut of cabbages, then the price will be low, encouraging people to buy cabbages.  Since there are so many cabbages, some might not be sold, causing waste.  Some farmers will decide to switch to more profitable crops for the next season, which reduces the supply of cabbages and brings the price back up.

There’s no need for a central authority to tell farmers which crops to grow, because prices send signals to farmers about shortages and surpluses.

Who gets which resources?

What happens when there is a choice about how to use a particular resource?

Take apples, which can be used in many different ways.  How does the apple farmer decide whether to sell her apples to the juice factory or the jam maker?

If jam making is more profitable than juice making, then the jam maker can get the apples by paying a higher price for them.  The jam maker outbids the juice factory because it adds the most value to the apples.  

This doesn’t mean that all apples will be sold to jam makers – if this happened, the resulting oversupply of apple jam would cause jam prices to crash and reduce the maximum price that the jam maker is able to pay for the apples.  Instead, the juice factory and the jam maker will get apples in a proportion that reflects the relative value to the market of juice and jam.

Juice or jam?  The market decides.  Image credit: mploscar.

The profit motive directs resources to where they are the most valuable to the market, simply through businesses acting in their own interests.  In fact, because all transactions in a truly free market are voluntary, every transaction should make the buyer and seller better off, leading (so the theory goes) to greater total wellbeing across society.

The dark side of the profit motive

You’ve probably already spotted some problems with this system.

Some economists say that at the market price, products are being allocated efficiently.  To quote Investopedia, “everyone (individuals, firms, or countries) is satisfied with the current economic condition” when supply equals demand.  This ignores the huge problem that anyone who wants or needs the product, but who can’t afford the market price, can’t get it.  Most of the 795 million hungry people in the world are hungry because they are poor, despite there being more than enough food to go around (World Hunger).

Furthermore, the profit motive prioritises what richer people want over what poorer people need.  Free markets may automatically send resources to where they are most valuable, but even if two people need the same item with the same urgency, the richer person can afford to pay more for it.  Market value therefore doesn’t necessarily correspond to degree of usefulness.

Voluntary transactions might make both buyer and seller better off, but transactions can also have side-effects that harm other people, meaning that overall wellbeing in society doesn’t necessarily increase.  The side-effects are known as negative externalities.  Examples include air pollution from cars, noise from factories and litter.

So, although the profit motive is supposed to maximise overall social wellbeing, it doesn’t necessarily work that way in reality.

A quick recap

We’ve seen that the profit motive drives businesses to make things that help customers.  Market price, determined by the balance between supply and demand, indicates which products are most valued by customers.  The profit motive is supposed to correct shortages and surpluses and send resources to where they are most useful.  However, many people cannot afford the things they need, the market often puts the wants of richer people before the needs of poorer people and people can be harmed by the side effects of profitable transactions.

In the next post, I’ll investigate why negative externalities account for much of the damage being done to the planet.  To make sure you don’t miss it, sign up for email updates below.

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